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Why the US sub-prime
mortgage bust will spread to the global finance system
By
Henry C.K. Liu
This article
appeared in AToL on March 16, 2007
Years earlier, when
the debt bubble spread over to the
housing sector, warnings from many quarters about the systemic danger
of
sub-prime mortgages have been categorically dismissed by Wall Street
cheerleaders as Chicken Little – “sky is falling” hysteria. Even weeks
before bad
news on the housing finance sector was shaping up as a clear and
present danger,
adamant denial was still loud enough to drown out reason. Both Federal
Chairman
Ben Bernanke and Treasury Secretary Henry Paulson, two top officials in
charge
of US monetary
policy, continue to provide obligatory assurance to the nervous public
that the
economic fundamentals are sound in the face of a jittery market. Days
before
being de-listed from the New York Stock Exchange, shares of the
collapsed New
Century, a distressed sub-prime mortgage lender, were recommended by a
major
Wall Street brokerage firm as a “buy”. The
firm is now under criminal and regulatory investigation.
On the pages of Asia
Times on Line over the past two years,
I have tried to put forth the rationale for the inevitability of a
housing
bubble burst, pointing out reasons why the resultant financial meltdown
will be
much more widespread and severe than had been generally acknowledged.
On September
14, 2005, I wrote in:
Greenspan,
the Wizard of Bubbleland
History has shown
that the Fed, more often than not, has
made wrong decisions based on faulty projection. Greenspan has been
rightly
criticized for letting a housing price “bubble” develop, equating it to
the one
that swept technology stocks to stratospheric levels before bursting in
2000.
Greenspan argues the Fed’s role is to mop up after bubbles burst, since
bubbles
are hard to spot and deflate safely. But accidents are also difficult
to
predict, and that difficulty is not a good argument against buying
insurance.
There is no doubt that there is a price to be paid for every policy
action. But
the price of prematurely slowing down a debt bubble is infinitely lower
than
letting the bubble build until it bursts uncontrollably. In finance as
in
medicine, prevention is preferable to even the best cure. All market
participants know pigs lose money. And a monetary pig loses control of
the
economy.
Greenspan,
notwithstanding his denial of responsibility in
helping through the 1990s to unleash the equity bubble, had this to say
in 2004
in hindsight after the bubble burst in 2000: “Instead of trying to
contain a
putative bubble by drastic actions with largely unpredictable
consequences, we
chose, as we noted in our mid-1999 congressional testimony, to focus on
policies to mitigate the fallout when it occurs and, hopefully, ease
the transition
to the next expansion.”
By “the next
expansion”, Greenspan meant the next bubble, which
manifested
itself in housing. The mitigating policy was a massive injection of
liquidity
into the US
banking system. There is a structural reason that the housing bubble
replaced
the high-tech bubble. Houses cannot be imported like manufactured
goods,
although much of the content in houses, such as furniture, hardware,
windows,
kitchen equipment and bath fixtures, is manufactured overseas.
Construction
jobs cannot be outsourced overseas to take advantage of wage arbitrage.
Instead, some non-skilled jobs are filled by low-wage illegal
immigrants. Total
outstanding home mortgages in 1999 were US$4.45 trillion and by 2004
this
amount grew to $7.56 trillion, most of which was absorbed by
refinancing of
higher home prices at lower interest rates. When Greenspan took over at
the Fed
in 1987, total outstanding home mortgages stood only at $1.82 trillion.
On his
watch, outstanding home mortgages quadrupled. Much of this money has
been
printed by the Fed, exported through the trade deficit and re-imported
as debt.
The most popular of
all derivative products is the interest-rate
swap, which in essence allows participants to make bets on the
direction
interest rates will take. According to the Office of the Comptroller of
the
Currency (OCC), interest-rate swaps accounted for three out of four
derivative
contracts held by commercial banks at the end of 1999. The notional
value of
these swaps totaled almost $25 trillion; 2-3% of that ($500 billion to
$750
billion) reflected the banks' true credit risk in these products.
Monetary
economists have no idea whether notional values are part of the money
supply
and with what discount ratio. As we now know from experience, creative
accounting has legally and illegally transformed debt proceeds as
revenue.
The OCC 2005 Report
on Condition and Performance of
Commercial Banks shows that loan demand grew at 11% in the first
quarter of
2005 while core deposits grew at 7%, producing a 4% gap. That meant
that banks’
loan growth was not fully funded by deposits. The report identified
possible
risks as: cooling off in housing markets accompanying slower loan
growth; past
regional housing price declines lingering; credit quality problems in
housing
spilling over to other loan types. Not a comforting picture.
Derivatives of all
kinds weigh heavily on banks’ capital
structures. But interest-rate swaps can be especially toxic when
interest rates
rise. And since only a few business economists predicted a jump in
rates for
the first half of the year when 1999 began while yields in fact rose
25%, these
institutions found themselves on the wrong side of an interest-rate
gamble by
2000. Moreover, as interest rates rose, banks’ income diminished from
interest-rate-related businesses, such as mortgage lending.
Interest-sensitive
sources of income were the revenue disappointment in 2000, as trading
was in 1999.
The banks’ response was to lower credit requirement for loans [to
increase
interest rate spread].
On Greenspan's
18-year watch, GSE (government-sponsored
enterprises) assets ballooned 830%, from $346 billion to $2.872
trillion. GSEs
are financing entities created by the US Congress to fund subsidized
loans to
certain groups of borrowers such as middle- and low-income homeowners,
farmers
and students. Agency MBSs (mortgage-backed securities) surged 670% to
$3.55
trillion. Outstanding ABSs (asset-backed securities) exploded from $75
billion
to more than $2.7 trillion. Greenspan presided over the greatest
expansion of
speculative finance in history, including a trillion-dollar hedge-fund
industry, bloated Wall Street firm balance sheets approaching $2
trillion, a
$3.3 trillion repo (repurchase agreement) market, and a global
derivatives
market with notional values surpassing an unfathomable $220 trillion.
Granted,
notional values are not true risk exposures. But a swing of 1% in
interest rate
on a notional value of $220 trillion is $2.2 trillion, approximately
20% of US
gross domestic product (GDP).
This practice of
borrowing short-term at low interest rates
to lend long-term at higher interest rates, known as "carry trade" in
bank parlance, when globalized by deregulated cross-border flow of
funds,
eventually led to the Asian financial crisis of 1997 when interest-rate
and
exchange-rate volatility became the new paradigm. Today, there are
undeniable
signs that the same interest-rate risks have infested the housing
bubble in
recent years. And the Fed's traditional gradualism, now revived as
"measured pace" in raising the FFR [Fed Funds rate] targets in
response to rapid asset price inflation, has had little effect in
curbing bank
lending to fund rampant speculation.
In recent months,
Greenspan has repeatedly denied the existence of a
national
housing bubble by drawing on the conventional wisdom that the US
housing market is highly disaggregated by location, which is true
enough.
Disaggregated markets are normally not exposed to contagion, a term
given to
the process of distressed deals dragging down healthy deals in the same
market
as speculator throw good money after bad to try to stem the tide of
losses. But
the bubble in the housing market is caused by creative housing finance
made
possible by the emergence of a deregulated global credit market through
finance
liberalization. The low cost of mortgages lifts all house prices beyond
levels
sustainable by household income in otherwise disaggregated markets.
Under cross-border
finance liberalization, negative wealth effects from
asset-value correction are highly contagious. For example, the Dallas
Fed Beige
Book released on July 27 states: “Contacts say real-estate investment
is
extremely high in part because the district's competitively priced
markets are
attracting investment capital from more expensive coastal markets.” The
nationwide proliferation of no-income-verification, interest-only,
zero-equity
and cash-out loans, while making financial sense in a rising market, is
fatally
toxic in a falling market, which will hit a speculative boom as surely
as the
sun will set. Since the money financing this housing bubble is sourced
globally, a bursting of the US
housing bubble will have dire consequences globally.
Through
mortgage-backed securitization, banks now are mere
loan intermediaries that assume no long-term risk on the risky loans
they make,
which are sold as securitized debt of unbundled levels of risk to
institutional
investors with varying risk appetite commensurate with their varying
need for
higher returns. But who are institutional investors? They are mostly
pension
funds that manage the money the US
working public depends on for retirement. In other words, the aggregate
retirement assets of the working public are exposed to the risk of the
same
working public defaulting on their house mortgages. When a homeowner
loses his
or her home through default of its mortgage, the homeowner will also
lose his
or her retirement nest egg invested in the securitized mortgage pool,
while the
banks stay technically solvent. That is the hidden network of linked
financial
landmines in a housing bubble financed by mortgage-backed
securitization to
which no one is paying attention. The bursting of the housing bubble
will act
as a detonator for a massive pension crisis.
On September 29, 2005, I wrote in:
THE WIZARD OF
BUBBLELAND
Part
2: The repo time bomb
Commercial banks
profit from using low-interest-rate repo
proceeds to finance high-interest-rate “sub-prime” lending - credit
cards, home
equity loans, automobile loans etc - to borrowers of high credit risks
at
double-digit interest rates compounded monthly. To reduce their capital
requirement, banks then remove their loans from their balance sheets by
selling
the CMOs (collateralized mortgage obligations) with unbundled risks to
a wide
range of investors seeking higher returns commensurate with higher
risk. In
another era, such high-risk/high-interest loan activities were known as
loan-sharking. Yet Greenspan is on record as having said that systemic
risk is
a good tradeoff for unprecedented economic expansion.
Repos are now one of
the largest and most active sectors in the US
money market. More specifically, banks appear to be actively managing
their
inventories, to respond to changes in customer demand and the
opportunity costs
of holding cash, using innovative ways to bypass reserve requirements.
Rising
customer demand for new loans is fueled by and in turn drives further
down
falling credit standards and widens interest-rate spread in a vicious
cycle of
unrestrained credit expansion.
Again, on October 27, 2005, I wrote in:
THE WIZARD OF BUBBLELAND
Part 3: How the US money market
really works
When asset prices
rise, it reflects a change in the money
supply/asset relationship, meaning more money chasing the same number
of
assets. Thus when asset prices rise, it is not necessarily a healthy
sign for
the economy. It reflects a troublesome condition in which additional
money is
not creating correspondingly more assets. It is a fundamental
self-deception
for economists to view asset-price appreciation as economic growth. A
housing
bubble is an example of this.
Money now,
especially virtual money, is created quite
independently of Fed action, and money creation has become much less
sensitive
to interest-rate fluctuations. This explains why the measured pace at
which the
Fed has been raising the Fed funds rate target has little direct or
immediate
effect on the housing bubble.
On January 11, 2006,
I wrote in:
Of Debt, Deflation and
Rotten Apples
In the US,
where loan securitization is widespread, banks are tempted to push
risky loans
by passing on the long-term risk to non-bank investors through debt
securitization. Credit-default swaps, a relatively novel form of
derivative
contract, allow investors to hedge against securitized mortgage pools.
This
type of contract, known as asset-back securities, has been limited to
the
corporate bond market, conventional home mortgages, and auto and
credit-card
loans. Last June, a new standard contract began trading by hedge funds
that
bets on home-equity securities backed by adjustable-rate loans to
sub-prime
borrowers, not as a hedge strategy but as a profit center. When bearish
trades
are profitable, their bets can easily become self-fulfilling prophesies
by
kick-starting a downward vicious cycle.
Total outstanding
home mortgages in the US
in 1999 were $4.45 trillion, and by the end of 2004 this amount grew to
$8.13
trillion, most of which was absorbed by refinancing of higher home
prices at
lower interest rates. When Greenspan took over at the Fed in 1987,
total
outstanding home mortgages in the US
stood only at $1.82 trillion. On his 18-year watch, outstanding home
mortgages
quadrupled to $8.821 trillion by the end of third-quarter 2005. Much of
this
money has been printed by the Fed, exported through the trade deficit
and re-imported
as debt [in the capital account surplus]. Given that new housing units
have
been about 5% of the US housing stock per year, at the rate of about 2
million
units per year, the housing stock increased by 100% over a period of 18
years
while outstanding mortgages increased by more than 400%.
The Bank of Japan’s
zero-interest policy, combined with general asset
deflation
in the yen economy, has caught the Japanese insurance companies in a
financial
vise. Both new loan rates and asset values are insufficient to carry
previous
long-term yields promised to customers. Japan
does not have a debtor-friendly bankruptcy law, as the US
has. At any rate, insurance companies, like banks, cannot file for
bankruptcy
in the US. As a
regulated sector, insurance companies are governed by an insurance
commission
in each state, which normally has a reinsurance fund to take care of
unit
insolvency. The funds are nowhere near sufficient to handle systemic
collapse.
The same happened to the US Federal Deposit Insurance Corp (FDIC) in
the 1980s.
The insurance sector
in the US
will face serious problems as the Federal Reserve again lowers the Fed
Funds
rate targets and keeps them near zero for extended periods. Several
segments of
the insurance sector, such as health insurance and casualty insurance,
are
already in distress for other reasons. Government-insured pension
schemes are
under pressure as troubled industrial giants such as General Motors
default on
their pension obligation, along with the airlines.
In the era of
industrial capitalism, a low interest rate was a
stimulant. But
in this era of finance capitalism flirting fearlessly with debt,
lowering rates
creates complex problems, especially when most big borrowers routinely
hedge
their interest-rate exposures. For them, even when short-term rates
drop or
rise abruptly, the cost remains the same for the duration of the loan
term, the
only difference being that they pay a different party. While debtors
remain
solvent, investors in securitized loans go under. Credit derivatives
have been
the hot source of profit for most finance companies and will be the
weapon of
massive destruction for the financial system, as Warren Buffet warned.
Again on February 16, 2006 I wrote in:
THE WIZARD OF
BUBBLELAND
Part
4: The global money and currency markets
In the United
States,
when house prices have generally tripled in less than a decade, it is
evidence
that the value of the dollar has declined by a factor of three in the
same time
period. Consumer prices have not risen by the same amount because of
outsourcing of manufacturing to low-wage economies overseas which also
acts as
a depressant on domestic wages. Imbalance in the economy appears if
wages and
earnings have not risen proportional to prices. A homeowner whose house
has
increased 300% in market price while his income has risen only 30% has
not
become richer. He has become a victim of uneven inflation. He may enjoy
a
one-time joyride with cash-out financing with a new mortgage, but his
income
cannot sustain the new mortgage payments if interest rates rise, and he
will
lose his home. And interest rates will rise if his income increases,
because
that is how the Fed defines inflation. Thus when his income rises, the
market
price of his home will fall, giving him an incentive to walk away from
a big
mortgage in which he has little equity tie-up. This can become a
systemic
problem for the mortgage-backed security sector.
That, dear readers,
is why the US
sub-prime mortgage bust will spread and cause severe damage to the
global
finance system.
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