Hell, Meet Handbasket, Part I
Currently, we find ourselves in a mess that many are calling the most serious economic crisis since the Great Depression. If not worse. A mile-high mountain of paper profits has been set ablaze and reduced to ashes, choking investors who put their faith in houses, stocks, or commodities, or…or…just about anything else you can name. Casey Research’s Doug Hornig explores…
Until recently, average Americans were only dimly aware that there were two types of banks – the commercial banks nearby and the major investment banks located in faraway New York. Understanding the bank where they conducted business, with people they knew, was enough. The big, impersonal Wall Street banks – which dealt in higher-risk investments with potentially higher rewards – were for companies and the very rich.
While ordinary citizens thought little about the distinctions among banks, the government did. Seventy-five years ago, as the Depression deepened, lawmakers were desperately trying to determine the causes of the crisis (read, looking for scapegoats). Some of the things they found were conflicts of interest and opportunities for fraud linked to the mixing of commercial and investment banking.
Congress decided to erect a “wall” between commercial and investment banking, and so passed the Banking Act of 1933, usually referred to as the Glass-Steagall Act. Glass-Steagall created the Federal Deposit Insurance Corporation (FDIC) to protect depositors in commercial banks, and it forbade commercial banks to underwrite securities or act as stockbrokers or dealers.
Glass-Steagall remained in force for six and a half decades, although various deregulatory measures and changes in exchange rules chipped away at it. Notably, in 1970 a rule excluding public companies from membership in the New York Stock Exchange was dropped. The last major private institution, Goldman Sachs, went public in 1999. This allowed investment banks to sell stock to any potential investor and greatly expand their capital base.
Over the last two decades of the 20th century, the financial industry lobbied vigorously for the repeal of Glass-Steagall and, in 1999, they got their way with the enactment of the Financial Services Modernization Act. The door was opened to consolidation in the banking industry.
With one stroke of a pen, commercial bankers could begin turning their loans into investment products. (Glass-Steagall had prevented them from selling debt-backed securities for which they were the underwriters.) And Wall Street investment banks were suddenly in the mortgage business. It would prove to be a marriage made somewhere significantly south of heaven.
We’re not fans of government regulation, but a deregulated marketplace carries with it certain imperatives. It functions as it should only in the absence of both criminal and boneheaded behavior. We can erect oversights meant to prevent the former and laws to punish it after the fact. But all the regulation in the world won’t do much about the latter, since both market traders and the regulation itself may be boneheaded.
The biggest factor here was the removal of Glass-Steagall prohibitions, but there were two other important tweakings.
The Commodities Futures Modernization Act of 2000 transformed the new mortgage-backed securities into a commodity, enabling them to be traded on futures exchanges with little oversight by any federal or state regulatory body.
Completing the trifecta, the Securities and Exchange Commission in 2004 waived its leverage rules. Previously, broker/dealer net-capital rules limited firms to a maximum debt-to-net-capital ratio of 12 to 1. But under the new regulations, five companies – Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanley – were granted an exemption, which they promptly used to lever up 20, 30, even 40 to 1.
Just as Congress was repealing Glass-Steagall, the tech stock bubble was inflating beyond sustainability. It would soon be pricked, ushering in a brief recession during which investors began the hunt for the next big thing.
Well, how about housing?
Back in 1977, Congress passed the Community Reinvestment Act, which had the goal of extending homeownership to the largest possible pool of Americans. Over the next 25 years, legislative supplements, a robust housing market, and aggressive government enforcement of “fairness in lending” combined to weaken bank standards of who did or didn’t qualify for a loan.
But that was just the beginning. In an effort to end a recession in the new century’s first years, the Greenspan Fed reduced interest rates to near nothing and poured liquidity into the financial markets. At the same time, capital that had fled the stock market was looking for action.
The commercial banks – and independent mortgagors like Countrywide Credit – were awash in cash. They started lending it, and every borrower’s credentials were deemed excellent, even those with low income, bad credit, and no money for a down payment.
The perfect storm was building. But at first, boy, did things ever look rosy. The country’s homeownership rate – 62.1% in 1960, rising to only 64.1% in 1994 – shot up to 68.9% by 2006.
As homeowner mania seized hold of the public imagination, people began treating their homes as ATMs. If they needed cash, they borrowed against their growing equity. Real estate speculators flipped houses like crazy. Why not, when there’s no risk? Housing prices only head in one direction, up, up, up, right?
It sure looked that way. The yearly average median price of an existing home went from $23,000 in 1970, to $62,200 in 1980, to $97,300 in 1990, to $147,300 in 2000 and crested at $221,900 in 2006. Astonishingly, despite recessions in the early ’80s and early ’00s, there wasn’t a single down year for housing in all that time.
However, in 2007 housing became the latest bubble to burst, pricked by unrealistic prices, overbuilding, and the retreat from ultra-low interest rates. Concurrently, as house prices finally began to drop, a whole bunch of those no- or low-interest loans began to reset.
Despite the well-earned reputation of some Wall Street high rollers, bankers tend not to be a reckless lot, nor financial dunces. In general, they would rather deploy a large amount of capital into a safe, low-yield investment than put a small amount of capital into something with very high risk.
With the new environment, however, the game changed. Commercial bankers found themselves making loans to shakier and shakier recipients, while at the same time, the investment banks and their clients were clamoring for new investment products.
So bankers did what any conservative person would do. They hedged their bets. They bundled up their loans and sold the packages to the investment banks. The outcome was essentially the mortgage business being uprooted from the commercial banks and transplanted into the investment houses, which have far less restrictive requirements about reserve capital, far fewer limits on the buying and selling of securities, and far less regulatory oversight.
The investment banks did not set out, of course, to become landlords. They just wanted some product to sell for which there was a ready market. As capitalist ingenuity collided with profit motive, they found there was no shortage of products that could be created; the mortgage bundles were sliced, diced, and repackaged into a bewildering array of securities, like structured investment vehicles (SIVs), collateralized debt obligations (CDOs), mortgage-backed securities (MBSs), and on and on.
The extent of the slicing and dicing into what financial chefs refer to as tranches was such that the original mortgage might be tossed from buyer to buyer, or even itself split into parts. Each time a package was put together and sold, the seller stretched to get top dollar for each tranche, requiring the underlying assets to be risk-rated and then assigned real-world value. In the end, rating services had little idea what they were rating (we’re being charitable here), and buyers had no idea what their purchase was really worth.
And always lurking in the background was the possibility that defaults on the mortgages supporting the entire process could have a profound ripple effect, given that these products became increasingly leveraged. Knowing this, traders invented credit default swaps (CDSs), those gnarly little creatures that morphed into Godzilla after 2004.
CDSs are an insurance policy, a way of dealing with fear, and a device for attenuating the risk inherent in trading products one may not fully understand. Those buying the protection pay an upfront amount and yearly premiums to the protection sellers, who agree in return to cover any loss to the face value of the security. The result is a private, two-party contract, devoid of regulatory oversight.
There are a bunch of nasty horseflies in this particular ointment. For one, the holder of that security (who is now “protected” by a CDS) might turn around and sell it to a third party, who might himself insure and resell it, and so on, creating an impossibly complex chain of ownership and obligation. Additionally, the CDS itself can be traded over the counter. Furthermore, any of the underlying assets might also get partitioned into different tranches, adding to the confusion. And finally, short sellers can work on just about any joint in the structure.
And here’s the really big rub. Suppose the party providing the initial insurance protection – having already collected its upfront payment and premiums – doesn’t have the money to pay the insured buyer when a default occurs. Or suppose the “insurer” goes bankrupt. In either instance, the buyer who thought he was protected finds himself left naked and alone.
However, that possibility seems not to have been considered as the financial world created an interlocking system of derivatives that not even a Cray supercomputer could sort out. The only certainty: it was an arrangement that depended on a robust economy and rising house prices.
Except, of course, things didn’t work out that way.
When the housing slump hit, defaults in the relatively small subprime sector (less than 20% of mortgages) started a chain reaction that raced through the derivatives market, the effects compounding geometrically, until finally the world financial structure was facing collapse.
To be continued, tomorrow…
for The Daily Reckoning
November 12, 2008
Protecting your assets is not just a buzzword anymore, it’s mandatory if you want to keep yourself and your family financially safe in these tough times…which will only get tougher in the near future.
Poor Mountain House, California.
The town is underwater, reports the International Herald Tribune. Nine out of ten houses are worth less than their mortgages. There are some 1,856 mortgaged properties in the zip code area of Mountain House. Only 209 of them have any positive equity.
How the screw turns! Is this the “ownership society” promoted by the Bush Administration? Now, people own less than ever!
There are said to be almost 8 million houses with negative equity in the United States.
Of course, people own a lot less in stocks than they did a few months ago too. Worldwide, stocks have shucked off about $28 trillion worth of value.
Poor…rich…middle class – everyone has been hit. The marginal homeowner has already been tossed out onto the street. And now comes word that an extraordinary resort in Montana, designed for the super-rich, has gone bust.
“Where did the money go?” asked Montana governor Brian Schweitzer, speaking of Tim and Edna Blixseth’s swanky resort in the Gallatin mountains. Of course, he might have been referring to almost anything – the Russian stock market, the oil market, the mining industry, Wall Street…everywhere you look…from trailer parks to Park Avenue…poof!… the money’s disappeared.
The oil price is signaling more doom and gloom ahead too. It slipped below $60 yesterday…
… And now, in the art market, “prices finally plunge,” reports the Daily Telegraph. An auction in New York of Impressionists and modern art was supposed to bring in $800 million. Instead, it barely fetched half that much – only $470 million by Friday night. Some lots didn’t sell at all. Only 60% of the artworks sold…at prices most about 30% below estimates.
Let’s take a quick look at how these losses are transformed from financial problems into economic problems.
“The domino effect,” is how today’s Independent describes it.
On the cover is the photo of a “news agent,” someone who runs a little shop selling magazines, newspapers, snacks, and so forth.
“Hit by falling sales, he decided not to repair his window. Thousands of other people did likewise. So Chemix, a chemical company in Stockport that supplies the building trade, went out of business – with 60 people losing their jobs. These are the sort of tiny decisions that lay behind the loss of 5,000 jobs yesterday. And this is why experts predict 2,000,000 people [in England] will be unemployed by Christmas.”
In the United States, the figure is 10 million.
So great is America’s economic squeeze that people can’t even afford a cup of coffee. Starbucks reports that its profits are off 97%. Not much left.
And, yesterday, General Motors shares fell to a new low of $2.79. The last time you could have bought the automaker so cheaply was in 1937. Back then, it would have been a good investment. The U.S. auto industry was on the way up. Now, Detroit is going down – hard. In the town itself, you can buy mansions for pennies. Empty warehouses are available almost for free. But who wants them?
Investors fear GM may run out of cash within weeks and be forced into bankruptcy. Nancy Pelosi says a special lame duck session of Congress may be called to get emergency cash to Detroit.
Of course, that’s they way the feds do business – always trying to prop up failures…trying to block progress…trying to delay the process of correction. In short, they’re trying to stop “nature’s delight” – change.
Meanwhile, the Dow fell another 176 points. The panic is gone, but the retreat continues. The Dow stood at 8,694 at the close of business yesterday.
At these prices, many investment pros are ready to get back in. Stocks are a bargain, they say. You get more value for money than you got in years, they point out. “Both my money and my mouth say the same thing,” adds Warren Buffett: “Buy equities.”
Take a look at Starbucks, for example. It used to be such a growth company that shares traded at 50 times earnings. Now you can get them for 12 times earnings. But with collapsing earnings…the share price could fall a lot more.
The stock market bulls aren’t necessarily wrong. But we announced a “Trade of the Decade” in 2000 – sell stocks, buy gold. The decade has a few more months to run, so we’ll stick with it. At the beginning of this decade you could get about 40 ounces of gold for a unit of the Dow stocks. Now, you barely get 12. If you’d done the trade and stuck with it, you’d be up about 200%.
Besides, it looks to us as though the Dow is going to drop below 5,000 before this is over. Dividend yields have risen to almost 4%. When the dividend yield reaches 6%…and you can trade one ounce of gold for the entire Dow…call us.
*** A few months ago, we wondered what the surprise would be. Mr. Market always has some tricks up his sleeve. What must happen always happens, but never as you expect.
So when stocks started to slide and people began talking about a ‘soft landing for global growth,’ we wondered where the surprise would be.
Now we know. The downturn has been much more violent than almost anyone imagined. And it’s beginning to look as though the long-term damage could be much greater too.
Remember, a correction is equal and opposite to the deception that preceded it. Where was the deception of the boom years most concentrated? In two places – the United States and China.
Americans believed they could live beyond their means forever. China believed it could get rich by selling more and more manufactured items – even though its major customer couldn’t pay.
You’d expect the resulting suffering to be equal and opposite to the aforegone enjoyment too. That is, those who lived highest on the hog should fall the farthest, no? And those who benefited most from selling to these people should lose most money.
So far, we’ve seen the beginnings of these redressments. But probably only just the beginning. Some people in America have lost their houses… some have lost their jobs. Spending has begun to fall. But the typical American continues to enjoy a standard of living that most of the world’s people cannot afford – including most Americans.
It will get worse. The third quarter showed the biggest decline in consumer spending in 28 years.
This is a “balance sheet recession,” remember? Consumers, businesses, investors – all need to pay down debt and build up savings. This will mean a huge turnaround for everyone – especially consumers. They have to reduce their standards of living dramatically in order to save money. And especially the baby boomer consumers – who also have to sock away some cash for retirement.
Saving went out of style in the ’90s…but it’s becoming very popular, very fast. We’re going to see national savings rates rise…back to nearly 10%…and maybe beyond. This is exactly what consumers need to do. Consumers need savings. But the trend is murder on a consumer economy. A 10% savings rate means about $1.3 trillion in money that is NOT spent every year. (That’s why Obama is going to have a $2 trillion budget deficit…more on that tomorrow.)
And here comes the bad news from the Wall Street Journal: “Retail Losses Sap a Jobs Safety Net.”
We’re not sure how you sap a safety net. But for millions of people, when budgets got tight, someone could always go to work as a clerk in a retail shop. The money was poor, but at least it was money. And it filled in the gaps. For retired people…students…part-time working spouses – retail employment was always there…a fallback position…a “safety net.”
But with sales collapsing, the safety net is on the hard ground. The complaint of working stiffs used to be that “good jobs” were hard to find. You could always find a ‘bad job’ – flipping burgers or stocking shelves. But jobs with health benefits and union wages were few and far between. Now, even bad jobs are getting hard to find.
*** The other big loser will be China. Here, too, investors have suffered huge losses already. But China is still growing…still producing beaucoup stuff for people who no longer have the means or the desire to buy it.
“No one should underestimate Asia’s exposure to this crisis,” writes Richard Duncan in Far Eastern Economic Review. “At best, Asia is facing a severe recession. September 2008 may mark the end of the era of export-led growth, rather than merely the beginning of a more typical global recession. Asia’s export-led economic model is just as threatened as the Anglo-Saxon model of highly leveraged capitalism.”
The Daily Reckoning