Deleveraging: When Will They Ever Learn?

The recent recession was caused by the overexpansion of credit.  Part of the financial recovery from a bubble is the reduction of debt on a society's collective balance sheets (businesses, financial institutions, households, and governments.)  This reduction is referred to as "deleveraging."

The Economist's Buttonwood columnist worries that "the US is the only nation where it's possible to argue that any deleveraging has occurred."  For most developed countries, overall debt to GDP ratios are higher now than during the financial crisis.

Even that is not enough, he says: "Nevertheless, if you think the system was overgeared in 2007, at the height of a credit boom, then it's hard to argue it's not overgeared now. " "Gearing is British for levering.  Americans convert the noun, "leverage," into a verb for the same purpose.

Is that a Tear Rolling Down Alexander Hamilton's Cheek?

Alexander Hamilton was a pesky immigrant who saw Great Britain's creditworthiness and thus ability to borrow as important to its standing as a superpower as was the British navy.  As the republic's first Secretary of the Treasury, he set the U.S. on course to creating the dollar as the world currency built on the credit worthiness of U.S. treasury bonds.

Pity Mr. Geithner who fate it is to have Hamilton's job when we suffer the indignity of a credit downgrade.  Standard and Poor's announced after markets closed Friday that America's bonds have fallen from AAA to AA.

The announcement brought quick reactions.

Guess who said the following?

"The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone...
A little self-discipline would not be too uncomfortable for the United States, the world's largest economy and issuer of international reserve currency, to bear.

"For centuries, it was the exuberant energy and innovation that has sustained America's role in the world and maintained investors' confidence in dollar assets. But now, mounting debts and ridiculous political wrestling in Washington have damaged America's image abroad...
All Americans, both beltway politicians and those on Main Street, have to do some serious soul-searching to bring their country back from a potential financial abyss."

(A) A big bond investor
(B) A foreign upstart
(C) A news service
(D) All of the above
(E) None of the above

The correct answer is (D).  Saturday, in the wake of the downgrade,  Xinhua, China's official news service editorialized the words you just read.  The signed editorial was attributed to Yamei Wang.  It is embarrassing to be lectured by China especially when China is calling a spade a spade.

U.S. High Yield Default Spread Premia

March 10 2010  John Authers says that it is good news that the credit market is much less newsworthy than it used to be.  What are junk spreads compared to likely losses form default?  Deutche Banks provides some estimates and the trends.  (2m 57sec)

Do You Care a Rap About the Business Cycle?

John Maynard Keynes was perhaps the most imposing economist of the Twentieth Century.  He is the father of macroeconomics (John Hicks might be called the midwife: indeed Hicks is probably the most influential, although his influence across the board in modern economic theory is so pervasive he is seldom cited.)

Friedrich von Hayek developed the ideas of Wicksell and the Austrian School theory of capital based on Boehm-Bawerk and von Mises into a coherent theory of the business cycle which does much to explain the mess we are in.

Keynesian economics justifies the use of stimulus programs such as are being used around the world to revive the world economy.  Nations around the world are following President Richard Nixon when he said, "We are all Keynesians now."

One should not assume Keynes would approve of current economic policy.  At a meeting of American economists shortly before he died, Keynes remarked "Perhaps I am the only non-Keynesian in the room." (as quoted in Bran Domitrovic's Econonoclasts: the History of the Supply-Side Revolution.)





Many thanks to both Ryan Pendleton and the Kansas Policy Institute who alerted me to this.

Dr. Hoenig, the Hawk: We Need More of Them

Dr. Thomas Hoenig, President of the Kansas City Federal Reserve Bank, has been known as a monetary policy hawk in the past. If he has been part of the Federal Open Market Committee's consensus supporting negative real interest rates, he is a dove no longer. He told the American Economics Association (AEA) meetings, “Experience both in the US and internationally tells us that maintaining large amounts of stimulus over an extended period risks creating conditions that lead to financial excess, economic volatility and even higher unemployment at some point in the future.” Amen!

Hoenig vs. Bernanke

Hoenig and our current Fed Chairman, Ben Bernanke offered opposing views of history at the AEA meetings.

As George Santayana taught us, "Those who cannot learn from history are doomed to repeat it." So at issue is what role monetary policy played in creating the real estate bubble that caused the so called Great Recession of 2007-9. To Hoenig and to me it is clear that the over-expansion of credit that inflated the bubble had as its root cause the Fed's war against the paper dragon of deflation. Negative real interest rates in 2002-2005 and much too low rates in 2006 subsidized the creation of ever more esoteric securities which was the stuff from which Wall Street's leverage binge was made.  Negative real interest rates inflate investment bankers' profits and bonuses, misdirect productive resources into speculation, cause a dangerous correlation of returns, and subsidize the ever increasing financial roundabout production we saw during the recent bubble. Short term interest rates are the price for the raw materials with which investment banks create leverage in securities markets and financial engineers manufacture designer securities.Subsidize the raw materials and increase the supply.

Bernanke is a better student of the Great Depression of the 1930s than of the recent bubble. As John Cassidy relates, that Ben Bernanke "[r]ather than conceding that he and his predecessor, Alan Greenspan, made a hash of things between 2002 and 2006, keeping interest rates too low for too long, he said the Fed’s policies were reasonable and the main cause of the rise in house prices was not cheap money but lax supervision." Cassidy is moved to wonder in the Financial Times whether Ben Bernanke is "Decended From the Bourbons?" recalling "Talleyrand’s quip about the restored Bourbon monarchs: 'They have learned nothing and forgotten nothing.'”

Speech by Federal Reserve Chairman Ben S. Bernanke : "The Future of Mortgage Finance in the United States"

Darda: A Recession Is Unavoidable

Michael T. Darda, the chief economist of MKM Partners informs us in the Wall Street Journal, "The Treasury bailout plan to recapitalize the U.S. banking system may help the U.S. avoid a deep and protracted recession. But even if the plan succeeds, it almost surely will not prevent a recession."


Indeed, below the GDP figures, lifted by net exports, "Gross domestic purchases contracted during the second quarter. Gross domestic purchases also contracted during the fourth quarter of 2007, and only rose by 0.1% at an annual rate during the first quarter."

Furthermore: "Real retail sales growth has been negative on a year-to-year basis for nine consecutive months, the longest streak of declines since 1991. This data, and the tremendous spike in both jobless claims and the unemployment rate, are telltale signs of an economy that is in reverse gear."

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Martin Wolf on the Treasury Plan

The Financial Times'es Martin Wolf advises us that "Desperate times call for desperate measures. But remember, no less, that decisions taken in haste may shape the financial system for a generation. Speed is essential. But it is no less essential to get any new regime right."

Among other things he agrees on a plan proposed by Professor Calomiris: "If, as seems plausible, a scheme that imposes such pain on the financial sector would be rejected out of hand, the next best alternative would be injection of preference shares by the government into decapitalised institutions, on the lines proposed by Charles Calomiris of Columbia University. This would be a bail-out, but one that constrained the behaviour of beneficiaries, not least on payment of dividends. That would make it far better than dropping benefits on the unworthy, via mass purchases of overpriced toxic paper."

Are the Credit Crisis and the Unrelated?

If you think the answer is "no," Reuven Brenner connects the dots for you.

The Fed Has Cut the Discount Rate and Will Lend to Security Firms

The Fed has been busy. They cut the discount rate; they strong armed J.P. Morgan to buy Bear Stearns and Bear Stearns to sell themselves; and they lent J.P. Morgan $30 billion to make all this work. The repo market has seized up and that interferes with the Fed's ability to conduct monetary policy.

Hear more from the Wall Street Journal.

The Subprime Mortgage Credit Crisis & the Bursting of the Housing Bubble Drops Mortgage Mail Solicitations By 62%

Mintel Comperemedia research tracks direct mail sent to households. Their data show mortgage solicitations in the mail fell 62 percent in the third quarter from the same period last year. Not surprisingly, ARMs (adjustable-rate mortgages) no longer predominate. The proportion of offers for for adjustable-rate mortgages fell from 56 percent to 22 percent.

Prominent mortgage brokers and mortgage banks have gone bust while major players have with drawn from the market.


DM News reports that the Treasury facilitated plan to selectively freeze the rates on some ARMs is causing direct marketing pros to adjust their offers.

Mortgage Meltdown

Andy Laperriere argues that we see in the subprime mortgage market debacle the bursting of the housing bubble. But it is just the begginning. He asks "[w]hat role did the Fed's loose monetary policy from 2002-2004 play in fueling the housing bubble? Should the Federal Reserve reexamine its policy of ignoring asset bubbles?"

Mr. Laperriere, a managing director in the Washington office of ISI Group, comments in today's Wall Street Journal.

He goes on to say, "Stock markets world-wide have sold off the past few weeks over concerns the collapse of the subprime mortgage industry could prolong and deepen the housing slump and threaten the health of the U.S. economy. Federal Reserve officials and most economists believe the problems in the subprime mortgage market will remain relatively contained, but there is compelling evidence that the failure of subprime loans may be the start of a painful unwinding of a housing bubble that was fueled by easy money and loose lending practices."

The "wealth effect" has been a the tail wind boosting consumption growth and GDP. If house prices do fall 10 percent this year, it will feel like a Kansas gale in our faces. How far will it push us back?

Delinquencies on Home Morgages are Up to 4.95 Percent and Those on Subprime Mortgages Are Soaring

Trouble in the mortgage market

Delinquencies

Damian Paletta reports in the Wall Street Journal today that "[d]elinquency rates for subprime adjustable rate mortgages reached 14.44% in the fourth quarter of last year, jumping 122 basis points in three months...."

This is based on data from the Mortgage Bankers Association's National Delinquency Survey. "[D]elinquencies on one-to-four family homes jumped 28-basis points in the fourth quarter to 4.95%." These data are reported quarterly.

The Stock Market fell 242 points. The mortgage market's woes help pull equity prices down.

The role of fraud and brokers

Mortgage brokers had a money machine when interest rates were low, house prices rising, and mortgage refinancing was a boom business. When that boom faded, apparently some less scrupulous brokers wrote mortgages that have turned sour. How much of the problems in the subprime market result from fraud and how much from changing economics is not clear. Imprudent lending and borrowing are certainly a big part of the problem.

What is the effect on the economy and mail volumes?

Securitizing the pain

The last time that we had wide spread mortgage credit delinquencies and foreclosures was in the run up to the 1990-91 recession. At that time a much larger proportion of mortgages were on bank balance sheets. As banks wrote off assets reducing their capital, they cut back on business loans contributing to that recession. The conventional wisdom is that securitiztion reduces the economy's vulnerability to a wave of mortgage defaults. I am less sanguine.

Mail volumes

The real estate sector has been an important source of mail volumes in recent years. We should expect a cutback in solicitations from mortgage brokers. When the problems in mortgage markets overflow into credit card issuers, expect a cutback in credit card solicitations to the subprime market.

Turbulence

This was to be a busy week of U.S. economic news, but markets themselves grabbed the headlines.

Chinese stocks fell almost 9% in Shanghai overnight Tuesday. The Dow responded by dropping over 500 points as part of a world wide rout in share prices.

Among the economic news, there was plenty to make investors revise their expectations.

Alan Greenspan suggested there might be a recession in our future. (See below.)

GDP growth

The estimated growth of the U.S. economy was revised downward. The Commerce Department said GDP grew only 2.2 percent (that is a seasonally adjusted annual rate) far short of the 3.5 percent initially reported. That is one of the largest downward revisions in a long time. The main culprit was the estimate of inventory investment, although downward revisions of fixed business investment spending and consumer spending on durable goods and nondurable goods all contributed.

The fourth quarter saw a big inventory sell off. Although this pulled down estimated GDP growth by 1.35 percentage points (final sales grew 3.6 percent), a drop in inventories can be a good omen for future production. We must take a careful look at its composition.

New home sales dropped 16.6 percent in January.

The housing sector is continuing to worry investors. They are right to worry. The lenders who financed the run-up in house prices are now finding their capital strained. See Justin Lahart: "After Subprime: Lax Lending Lurks Elsewhere" and Robin Sidel And David Reilly, "No Worries: Banks Keeping Less Money in Reserve."


The fallout

Viewed from the vantage point of Thursday afternoon, investors seem to have taken Professor Greenspan’s advice. They are now a bit more risk adverse. Consequently stocks are a bit cheaper, government bonds a bit dearer, and high yield bonds’ yields are higher. And analysts are now a bit gun shy about saying the economy has nowhere to go but up.

Is My Understanding of the English Language Becoming Obsolete?

In today's Wall Street Journal, Joe Dickerson, an analyst at Atlantic Equities LLP, is quoted saying that J.P. Morgan "is making tangible progress on leveraging its diverse business model to the bottom line." Atlantic Equities is a London independent research firm.

What does he mean? By "diverse business model," does he mean that J.P. Morgan has multiple business models? Or does he mean that the bank's business model is based on a diversity of business (each with its own business model)?

I have a personal preference for the more straightforward verb "lever" over the rethreaded noun, "leverage." Whatever my preference, I know I am spitting into the wind on this one. That said, how does one lever a diverse business model to a bottom line? That is not a matter of levering or amplifying.

So what does he mean? My hunch is that J.P. Morgan has made progress integrating banks it has bought and achieving some economies of scope between such diverse businesses as securities trading, investment banking, retail banking, and credit cards. And perhaps he is right.

If I were an investor in J.P. Morgan, my worry would be this: The bank is gaining an earnings boost from over levered consumers who are falling back on their credit cards lines. Will that interest income disappear in the future when some of those balances evaporate into loan loss reserves?

Borrowing by Consumers Eases, But Credit-Card Balances Jump

The Wall Street Journal reports that American consumers' debt fell somewhat in September despite a rise in credit card debt. Yet debt burdens are rising as consumers rely more heavily on morgaging their homes and reduce their exposure by pulling back on credit card debt. The Wall Strret Journal reports, "As of the second quarter, mortgage payments had reached 11.6% of disposable income, the highest level since at least 1980. Consumer-debt payments had fallen to 6.5% of disposable income, the lowest level since late 2000."

As houses become more difficult to sell in the previously hot real estate markets, less mortgage financing will bleed through to consumer spending. A slowdown in both consumer spending and new housing is translating into slower U.S. growth. Will the housing bubble burst into a recession? It is too early to make that call.