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July 15, 2008 Crisis Widens
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The U.S. financial markets and the U.S. economy are in crisis and
the ramifications for the rest of the world are enormous. The
longstanding U.S. subsidization of housing is at the foundation of
this crisis. The housing priority has long directed too much of
U.S. government and private sector economic capacity to housing and
related consumer spending; this has left far too little for spending
on infrastructure (think high-speed trains, viable air systems,
roadways and energy development) and spending on a social safety net
(to reduce poverty, improve education, bolster health care, Social
Security and Medicare). Much of the government’s spending
capacity has also gone to defence.
Repeated tax cuts since 1980 and resurgence in Pentagon spending have
been reflected in today’s record budget deficit, enormous
government debt loads and the ever-widening gap between rich and poor.
The decisions regarding priorities reflect value judgments that most
Americans bought into; but the excesses of Wall Street and Main Street
and insufficient regulation of financial institutions and markets have
now crystallized the long-term consequences of these priority
decisions. While American income per capita is near the highest in the
world on average, much of the U.S. household balance sheet has proven
to be inflated by market excesses that are painfully unwinding.
Moreover, income and wealth disparities are higher than ever before as
a large proportion of the U.S. population has not benefited from the
recent surge in housing and equity markets.
Wealth destruction is now massive and far from over. The U.S. dollar
is down sharply since 2002 and will fall meaningfully further,
contributing to the increase in commodity prices and inflation. The
only offset to the dollar’s decline is the absence of any other
reserve currency. The euro has risen sharply and the Canadian dollar
is back near par, but the eurozone is weakening and may already be in
full recession for the first time since the launch of the single
currency. Other currencies are insufficiently liquid to act as an
alternative to the U.S. dollar: hence gold is rising and it will
continue to rise. Commodity prices boosted by the dollar’s fall
will deflate as the global economy slows as today’s fall in oil
prices suggests. The economic slowdown and conservation measures are
helping to offset the upward pressure on oil prices coming from U.S.
dollar weakness. The global slowdown combined with financial stress
provides the worst of worlds for stock markets as the slump in
financials is now joined by a decline in materials and industrial
companies.
European and Asian stock markets fell sharply today. Canada’s
TSX is bushwhacked by the fall in commodity companies along with the
continuing plunge in financials. Today’s data show that
industrial production for the EMU bloc fell 1.9% in May, which is the
sharpest one-month decline for the region since the exchange rate
crisis in 1992. Officials in Germany have warned that the economy
could contract by as much as 1.5% in the second quarter (a 6%
contraction at an annual rate) as exports crumble. Industrial output
in both Italy and Greece has slumped 6.6% in the past year, Portugal
is off 6.2%, and Spain is now spiraling into the worst crisis since
the Franco dictatorship. Housing crises are evident in Spain and the
U.K. where the British economy is also falling into recession. Over
10% of the Spanish economic growth has been in residential
construction; this compares to 6% to 7% of the U.S. economy at the
height of the bubble. Spain’s homebuilders are going bust and
share prices in this sector are crashing, leading to a suspension of
trading in the Madrid bourse. This not only hurts domestic homeowners
in Spain, but also many wealthy Europeans who have built homes on the
coastal areas accounting for much of the overbuilding.
Crisis Moves beyond Housing
The U.S. housing sector might have been the start of the problem, but
banks are now experiencing rising delinquencies on credit card and
term loans. Commercial real estate is also suffering. This
week’s announcement of the closure of the 276-store Steve and
Barry’s chain accompanies the shut down of other shopping-mall
stalwarts such as The Sharper Edge and The Bombay Company. Ann Taylor
and Talbots are closing many stores and Linens ‘n Things has
filed for bankruptcy protection. Countless smaller stores are closing
and shopping center vacancy rates are rising significantly. Industrial
loan weakness will be the next to follow. Retail sales are much weaker
with U.S. auto sales at a 15-year low. Layoffs are rising sharply and
the fear of unemployment is palpable. Daily announcements of major
layoffs accompanied by record-high gasoline and food prices as wealth
destruction continues have driven U.S. consumer confidence down to
very low levels. The only reason the U.S. economy has not posted
negative GDP growth is because of the improvement in net exports;
Americans aren’t buying imports, the prices of which have risen
sharply with the fall in the U.S. dollar, while exports are more
competitive. But this boost to the economy can’t last much
longer as global economic growth stalls and transportation costs
mount.
The financial crisis is spreading. Consumers in the United States are
losing confidence in their banks. Pictures of the long line-ups of
customers making withdrawals at IndyMac bank are displayed prominently
in every newspaper in the country. Last weekend, the FDIC took over
IndyMac, a large Pasadena-based mortgage lender. Covering the insured
deposits (balances up to $100,000) and some of the uninsured deposits
of IndyMac is expected to cost the FDIC $4 billion-to-$8 billion. The
FDIC has capital of about $54 billion raised from premiums paid by the
banks. Yesterday, every bank analyst in the U.S. published lists of
prospective bank failures. Their stock prices plunged sharply; for
example, Washington Mutual’s share price has fallen more than
22% since Friday’s close. Municipal investment pools and other
large depositors often hold large balances in local banks, which might
now be considered imprudent. Depositors will likely yank their money
from small-to-mid-sized banks to the large banks under the presumption
that they are too big to fail. This becomes a self-fulfilling
prophecy.
The risk of failure goes beyond the banks, as we saw last March with
Bear Stearns. Lehman Brothers’ stock price has come under
repeated downward pressure since March and is now down 79% this year.
The media have reported rumours that Lehman’s CEO Dick Fuld is
seriously considering a way to take Lehman private. According to the
NY Post, “the rationale is that the free-fall in
Lehman’s shares, which tumbled as much as 15% yesterday, is
attracting hungry vultures hoping to snap up the ailing fixed-income
shop on the cheap.”
Fannie and Freddie
The U.S. Treasury and the Fed are in the midst of a painful financial
triage—assessing which institutions are too big to fail, like
Fannie and Freddie, and which are not worth saving, hoping the FDIC
can handle much of the damage. Fannie and Freddie are so big and so
important for investors, sovereign and private, all over the world
that the U.S. government must, in essence, guarantee these guarantors
of roughly half the mortgages outstanding in the U.S. As Clive Crook
of the Financial Times put it yesterday,
“US taxpayers are about to find out what their long-standing and
(strictly speaking) non-existent guarantee of Fannie Mae and Freddie
Mac will cost them. One way to think of it is this: take the US
national debt of roughly $9,000bn and add $5,000bn. Not bad for an
obligation still officially denied.“
These GSEs are owners or guarantors of roughly $5 trillion of U.S.
home mortgages, or about 50% of mortgage debt outstanding. They are
currently involved in around 70% of new mortgages being originated. If
they were to go down they would take what’s left of the housing
market and the U.S. economy with them. This would be convulsive not
just for the U.S., but for a huge chunk of the rest of the world whose
coffers are stuffed with the IOU’s of Fannie and Freddie.
Foreigners owned roughly $1.4 trillion in U.S. agency debt at the end
of last year, the bulk of which was with Fannie and Freddie. Of that
total, China accounted for nearly 30% of that or $387 billion. Next
largest was Japan, holding just over 16% or $231 billion of agency
debt. Middle East oil exporters held $33.7 billion, the U.K. held $28
billion, Switzerland $18 billion, Germany $15 billion, France $11
billion and Canada held $4.7 billion. Much of this is held by foreign
central banks and other sovereign entities, but private investors
including commercial banks hold substantial sums as well. The
remaining $3 trillion-plus of GSE debt is held in the U.S. This is
truly nasty business.
Fannie and Freddie were launched as publicly traded companies to
“facilitate the credit and capital required to sustain”
the housing boom and serve a dual mission: “provide liquidity in
the mortgage market and maximize profits for shareholders,” all
beyond the regulation of the SEC. These institutions have oft been in
the news for suspect accounting practices.
Fannie and Freddie are undercapitalized. For Fannie, the ratio of
total leverage to preferred and common equity is a whopping 68.7, far
higher than for any of the Wall Street banks including Bear Stearns at
its peak. (For Freddie it is even higher). It only takes a modest
decline in the value of their mortgages to wipe out the equity of both
GSEs. While Barron’s cover article this week was called,
“Home Prices are About to Bottom,” I see ominous signs
that the bottom could still be a year or more away. Foreclosures and
delinquencies are mounting relentlessly and banks are finding it very
expensive to hold vacant homes. An unprecedented 10% of homes built
since 2000 are vacant even though house prices have already fallen
roughly 15% on a national basis. In highly overbuilt areas such as
those in California, Arizona, Nevada and Florida, the situation is
much worse. A sizable proportion of Fannie’s and Freddie’s
mortgage book is undeniably underwater, even without further declines
in the housing and mortgage market—and further declines there
will be. Arguably, the value of these homes and mortgages will be
depressed for a very long time—in some cases (though not many),
never returning to bubble highs given the aging population and
particularly hard hits to some parts of the economy.
The Fed, the Treasury, the White House, the Congress and the SEC are
doing everything they can to calm markets that are continuing to
punish financial stocks. The SEC announced this afternoon emergency
action aimed at reducing short-selling of Fannie and Freddie as well
as the stocks of Lehman Brothers, Goldman Sachs, Merrill Lynch and
Morgan Stanley. The emergency order requires traders to pre-borrow
stock before shorting these embattled companies. No mention yet of any
bank stocks. Earlier this week, the SEC announced actions to prosecute
rumour mongers.
Bottom Line: Housing is sacrosanct in the U.S. and it arguably
has the strongest lobby on Capitol Hill. Mortgage interest is tax
deductible and that includes home equity loans and most second
mortgages. Homeownership rates moved to a record high 69% in 2004Q2 as
housing was bubbling away. Fannie and Freddie (which securitize only
prime loans) and securitization of subprime loans by Wall Street that
were stamped triple-A by the rating agencies along with generation-low
interest rates causing everyone to take more risk were the causes of
the housing bubble; the wealth destruction and losses from the bubble
bursting have yet to be fully realized. American homeowners, long
subsidized by government tax breaks on mortgage interest payments (not
to mention property taxes), will now pay the bill for a good deal of
the bailout. While Congress will likely never (never say never)
eliminate mortgage interest deductibility, tax rates will have to be
raised to pay for this mess. The expanding U.S. budget deficit will
raise the cost of capital and lower the value of the dollar. This only
exacerbates the problems in financing needed social and infrastructure
spending. The next President has a very tough job.
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June 19, 2010
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Next Shock: Currency Crisis?
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