The Long Fall: A market without parachutes

This is perhaps rather pessimistic but the article does point out some of the difficulties that the US economy is facing. It seems that the dollar is being abandoned. If the US thinks that it can continue to spend billions and billions on wars as if there is an endless supply of money it had better think again. Also, the continual lending of money to purchase houses to clients who cannot afford to pay for them is now backfiring not just on the US but everyone who has bought securities based upon those loans.
China has little interest in the financial ruin of the US at this stage. If the US goes into deep recession that is one large market gone and instability could spread to other markets as well. Capitalist economies are globally interrelated.



The Long Fall

A Market Without Parachutes

By Mike Whitney

11/08/07 "ICH" -- -- America is finished, washed up, kaput. Foreign investors and central banks around the world have lost confidence in US markets and are headed for the exits. The dollar is sinking, the country is insolvent, and its leaders are barking mad. That’s bad for business. Investors are voting with their feet. They’ve had enough. Capital is flowing to China and the Far East in a torrent. It’s "sayonara" Manhattan and “Hello” Tiananmen Square.

Want some advice? Learn Mandarin.

The dollar fell another 2% last night, gold soared to $840 per ounce, oil topped $98 per barrel, General motors reported a $39 billion loss after the market closed on Tuesday, the real estate market continued its downward slide, and the major investment banks are marching in lock-step towards bankruptcy.

The news is all bad. The nation’s economic foundation is in shambles. US credibility is shot. Bush and Greenspan have put us on the road to ruin. Now their work is done. We’re flat broke.

The catalogue of fiscal ailments now facing the country is too long to list. We’d need a ledger the size of a small encyclopedia. There’s been a stampede away from the dollar even though it’s already lost over 60% of its value since Bush took office and even though central banks around the world will lose their shirts if it collapses. They don’t care. They’re getting out while they can.

Cheng Siwei, the vice chairman of China’s National People’s Congress, announced yesterday that China would continue to diversify its $1.4 trillion reserves away from the dollar to “stronger currencies” like the euro. “Strong currencies”; isn’t that Paulson’s line? Siwei’s comments ignited a firestorm in the currency markets triggering a big blow-off of the greenback. The poor dollar has no place to go now but down, and it’s on a greased pole to the bottom. With consumer spending paralyzed by the decline in home equity and frozen wages, and the banks “stuffed to the gills” with over a trillion dollars of mortgage-backed sludge; the prognosis for the hobbled dollar is looking grimmer by the day. The bulging trade deficits and dwindling foreign inflows haven’t helped either. The greenback has suddenly become the global pariah; all it needs is a leper’s rattle and a tin cup.

The news is no better in the real estate industry either, where the nation’s biggest builders are reporting record losses and inventory is backed-up 11 months. Sales are off 22% in one year alone. Foreclosures are skyrocketing, jumbo loans (over $417,000) are impossible to get regardless of one’s credit history, 40% of all mortgages (subprime, Alt-A, piggyback, reverse amortization, interest-only) have been eliminated, and entire projects in Florida, Arizona, Las Vegas, and California’s Central Valley have stopped building altogether. Tens of thousands of unoccupied homes across the Southwest have been reduced to ghost towns. Nothing is selling. The building boom, that began when Alan Greenspan ginned-up the Fed’s printing presses in 2002, has turned into the biggest housing bust in American history.

On top of that, the banks are tightening lending standards and shunning potential buyers just when the economy needs a boost in demand. Loan originations are down and bankers are spooked by the gathering storm in the credit markets. That means that home sales will continue to be sluggish, prices will correct more quickly, and the anticipated “soft landing” will turn into a full-blown crash.

New home construction has accounted for 2 out of every 5 new jobs created in the last 5 years. Most of those workers are either delivering pizzas, cleaning bed pans or are lining up at the soup kitchen. The BLS’s numbers on employment are bogus. It's just more government bunkum. They're predicated on a “birth-death” model that creates millions of fictitious jobs out of whole cloth. In truth, unemployment is soaring and the most vulnerable and impoverished among us are taking a beating from housing debacle.

According to the Mortgage Bankers Association of Washington, the total of mortgage loans outstanding in 2006 was $10.9 trillion; $6 trillion of which were transformed into securities. (CDOs, MBSs) About $1.5 trillion of those securities are subprime; another $1 trillion Alt-A (nearly as risky) and at least another $1.5 trillion in adjustable rate mortgages (ARMs) At least 20% of these shaky liabilities/securities will default, and yet, no one really knows who is holding them on their books. All of the major financial institutions—the insurance companies, foreign banks, hedge funds, investment banks---have purchased these CDO “roadside bombs” and mixed them in with their other performing loans and hard assets. The projected explosions have already begun to take their toll on the financial giants---Citigroup and Merrill Lynch are just the latest victims; others will follow. The problem can’t be fixed with Bernanke’s low interest rates. The bad debts are everywhere and must accounted for and written down. That puts us on the threshold of a jarring market-downturn triggered by an unprecedented number of defaults that will rumble through the entire system. Bankruptcies will pop up everywhere at random. It is a blueprint for economic chaos. And it is unavoidable.

The global markets have never seen a financial typhoon of this magnitude before. Mortgage lenders, homeowners, banks, hedge funds, bond insurers, etc. will all either go under or feel the sting of a slumping market.

Many of the major investment banks are already broke; it’s clear from their own reporting. Charles Hugh Smith sums it up like this in his recent article “Empire of Debt: The Great Unraveling”:

“If their bad bets were marked to market, Citicorp and Merrill Lynch would be declared insolvent. Why? Because they are insolvent--right now. The meaning of insolvency is straightforward: their losses exceed their capital. Recall that these firms list assets of $100 billion (or whatever) but their actual net capital is on the order of 2.5% to 5%---a mere sliver of their stated assets. In other words: a 5% loss of their stated assets wipes them out…..The game is now over, and the players shuffling losses can only last a few more days or weeks.”

Up to this point, the banks have been able to place a sizeable portion of their "hard-to-value" assets in a Level 3 grab bag, which allowed company accountants to assign a value to those assets according to their own judgment. No more. The new FASB 157 regulation will force the banks to use “market prices” to determine the true value of their holdings. Some analysts believe that these new disclosure rules may result in $200 billion write-downs on assets and require that the over-leveraged banks to increase their capital reserves. That will slow down lending and put a wrinkle in the banks' bottom line. In any event, once the law is enacted; we’ll see who’s "faking" the value of their assets or as Warren Buffet says, “Who’s swimming with their clothes off.”

Professor Nouriel Roubini summed it up like this:

“The amount of losses that financial institutions have already recognized - $20 billion – is just the very tip of the iceberg of much larger losses that will end up in the hundreds of billions of dollars….Calling this crisis a sub-prime meltdown is ludicrous as by now the contagion has seriously spread to near prime and prime mortgages…And it is spreading to every corner of the securitized financial system that is either frozen or on the way to freeze….The reality is that most financial institutions have barely started to recognize the lower “fair value” of their impaired securities….The credit crunch is getting worse and its financial and real fallout will be severe.” (Nouriel Roubini blog)

The constant drumbeat of bad news is having a numbing affect on Wall Street. Traders’ are tight-lipped and downcast. Spirits are sagging. No one likes loosing money, and yet, the credit storm shows no signs of letting up anytime soon. Yesterday, the Dow Jones Industrial’s took another 360-point pounding before the bell rang. Another day, another bloodbath. The subprime virus has now infected the broader markets leaving the once-brawny financial giants bruised and reeling like Joe Frazier in the Thrilla in Manila. A few more down-days like yesterday and they’ll be carrying out hedge funds feet first. The stock market is looking more and more like a glass pitcher propped up on the edge of a bookshelf. One little bump, and down she goes.






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A Minskian analysis of US economy and financial markets

This is from this site.
It is an interesting explanation of recent happenings in financial markets and if the Minskian analysis is correct what we might expect in the near future.


A Minskian analysis of US economy and financial markets
Posted by Marc Lee under history of economic thought, financial markets, US.
August 2nd, 2007
Comments: none

Nouriel Roubini invokes the great, but relatively unknown, Post-Keynesian economist, Hyman Minsky, in his latest dispatch about the state of US financial markets and economy. Minsky made the point that finance and financial markets matter, and in fact can have disastrous consequences for the real economy if left unchecked, and therefore institutions like prudent regulation and central banks are essential to keeping capitalism on the rails. This may seem somewhat obvious to the casual reader, but standard neoclassical economics often neglects the role of financial markets, and to the extent it is considered at all is often subjected to nostrums like the “neutrality of money” (that money does not matter because economic agents always see things in real and relative terms).
So here is Roubini, applying a Minskian analysis to the current US economy:
Are We at The Peak of a Minsky Credit Cycle?
… Hyman Minsky was an American economist who died in 1996. His main contribution to economics was a model of asset bubbles driven by credit cycles. In his view periods of economic and financial stability lead to a lowering of investors’ risk aversion and a process of releveraging. Investors start to borrow excessively and push up asset prices excessively high. In this process of releveraging there are three types of investors/borrowers. First, sound or “hedge borrowers” who can meet both interest and principal payments out of their own cash flows. Second, “speculative borrowers” who can only service interest payments out of their cash flows. These speculative borrowers need liquid capital markets that allow them to refinance and roll over their debts as they would not otherwise be able to service the principal of their debts. Finally, there are “Ponzi borrowers” cannot service neither interest or principal payments. They are called “Ponzi borrowers” as they need persistently increasing prices of the assets they invested in to keep on refinancing their debt obligations.
The other important aspect of the Minsky Credit Cycle model is the loosening of credit standards both among supervisors and regulators and among the financial institutions/lenders who, during the credit boom/bubble, find ways to avoid prudential regulations and supervisions.
Minsky’s ideas and model fit nicely the last two US credit booms and asset bubbles that ended up in a recession: the S&L-based real estate boom and bust in the late 1980s; and the tech bubble and bust in the late 1990s. But the experiences of the last few years suggest another Minsky Credit Cycle that has probably now reached its peak. First, it was the US households (and households in some other countries) that releveraged excessively: rising consumption, falling and negative savings, increased in debt burdens and overborrowing, especially in housing but also in other categories of consumer credit, an increase in leverage that was supported by rising asset prices (housing and, more recently, equity). We know now that many sub-prime borrowers, near-prime borrowers and many condo-flippers were exactly the Minsky “Ponzi borrowers”: think of all the “negative amortization mortgages” and no down-payment and no verification of income and assets and interest rate only loans and teaser rates. About 50% of all mortgage originations in 2005-2006 had such characteristics. Also, many other households (near prime and subprime borrowers) were Minsky “speculative borrowers” who expected to be able to refinance their mortgages and debts rather than paying a significant part of their principal.
The Minsky idea of loosening of credit/lending standards among mortgage lenders – and the phenomenon of supervisors/regulators falling asleep at the wheel while the reckless credit bubble occurs – is also now evident in the recent mortgage credit cycle. A supervisory ideology that tried to minimize any prudential supervision and regulation and totally reckless lending practices by mortgage lenders led to a massive housing and mortgage bubble that has now gone bust. The toxic waste aftermath of this bust includes more than fifty subprime lenders gone out of business this years, soaring rates of delinquency, default and foreclosure on subprime, near prime and non-conventional mortgages, and the biggest housing recession in the last few decades with now home prices falling for the first time – year over year – since the Great Depression of the 1930s.
While the process of releveraging started in the household sector – that is the most financially stretched sector of the US economy – the releveraging more recently spread to the corporate and financial system: in the financial system the rise of hedge funds, private equity and speculative prop desks led to a sharp rise in the financial system leverage. In the corporate sector given the cheapness - until recently - of credit we observed a massive process of switch from equity to debt that took the form of leveraged buyouts, share buybacks and privatization of formerly public companies. This releveraging fed that equity/asset bubble: as expectations of more LBOs occurred equity valuation of many firms went higher and higher. The excesses took recently the form of premia of 40-50% or higher on the stock price of firms that were a leveraged takeover target. Specifically, CLO demand for corporate debt helped fuel the private equity sponsored LBO wave over the past few years, and thus contributed to the recent bull market in equities. Notice also that the amount of issuance of low grade corporate bonds (below investment grade “junk bonds”) had been rapidly rising in the last few years.
While pure “Ponzi” borrowers were not as common in the corporate system, there is wide evidence of “speculative borrowers” who relied and still rely on continued refinancing of their debts. Ed Altman, a colleague of mine at Stern, is recognized as the leading world academic expert on corporate defaults and distress. He has argued that we have observed in the last few years record low default rates for corporations in the U.S. and other advanced economies (1.4% for the G7 countries this year). The historical average default rate for US corporations is 3% per year; and given current economic and corporate fundamentals the default rate should be – in his view - 2.5%. But last year such corporate default rates were only 0.6%, one fifth of what they should be given fundamentals. He also noted that recovery rates - given default - have been high relative to historical standards.
These low default rates are driven in part by solid corporate profitability and improved balance sheets. In Altman’s view, however, they have also been crucially driven - among other factors - by the unprecedented growth in liquidity from non traditional lenders, such as hedge fund and private equity. Until recently, their demand for corporate bonds kept risk spreads low, reduced the cost of debt financing for corporations and reduced the rate of defaults. Earlier this year Altman argued that this year “hot money” from non traditional lenders could move to other uses for a number of reasons, including a repricing of risk. If that were to occur, he argued that the historical patterns of default rates - based on firms’ fundamentals - would reassert itself. I.e. we are not in a new brave world of permanently low default rates. He said: “If we observe disappointing returns to highly leveraged and rescue financing packages, some of the hedge funds may find it difficult to cover their own loan requirements as well as the likely fund withdrawals. And broker-dealers who are not only providing the leverage to the hedge funds but whom are also investing in similar strategy deals will recede from these activities.” The same could be said of the consequences of the unraveling of some leveraged buyouts. Altman suggested that triggers of the repricing of credit risk could also be “disappointing returns to highly leveraged and rescue financing packages”. So he argued that the unraveling of the low spreads in the corporate bond market could occur even in the absence of changes in US and/or global liquidity conditions.
Thus, until recently the Minsky “speculative borrowers” in the corporate sectors included corporations that could service their debt only by refinancing such debt payments at very low interest rates and financially favorable conditions. While “Ponzi borrowers” were those firms that, under normal liquidity conditions, would have been forced into distress and debt default (either of the Chapter 7 liquidation form or Chapter 11 debt restructuring form) but were instead able to obtain out-of-court rescue and refinancing packages because of the most easy credit and liquidity conditions in bubbly markets.
The Minsky phenomenon of loosening credit and lending standards during a credit bubble included both the corporate borrowers and financial institutions. First, there are clear parallels between the mortgage market and the leveraged loan markets. These include corporate borrowers’ high leverage ratios, declining credit standards (“cov-lite” loans instead of subprime), PIK (or payment-in-kind) deals (variants of negative amortization), insufficient monitoring by lenders due to the “originate and distribute” model (loans repackaged into CLOs instead of CDOs), banks’ retained exposure (bridge loans as opposed to CDO equity tranche). In the financial system, margin requirement for hedge funds and other leveraged speculators became lower and lower as the competition for prime brokerage services for hedge funds among lenders became fierce.
Housing bubble, mortgage bubble, credit bubble, debt bubble and asset prices (equities, housing, prices of corporate debt and other risky loans) rising well below what could be justified by the economic and credit fundamentals. It certainly looked like a typical Minsky Credit Cycle. The first crack in this cycle was the bust of housing and of subprime mortgages in the US. The second crack was the spread of the subprime carnage to near prime and prime mortgages and to subprime credit cards and auto loans. The third crack is the most recent repricing of risk in a variety of credit markets and the beginning of a credit crunch in the LBO and corporate credit markets.
We are clearly now observing a significant worsening in US financial conditions and a peaking of the Minsky Credit Cycle in a variety of markets:
- a housing recession that is getting worse by the day and home prices now falling (for the first time since the Great Depression) as the housing asset bubble has now burst.
- a credit crunch in subprime that is now spreading to near prime (Alt-A) and prime mortgages (see the Countrywide financial results) and to subprime credit cards and subprime auto loans;
- massive losses - at least $100b in subprime alone and most likely to end up higher – in the mortgage markets;
- a significant recent increase in corporate yield spreads (by 100 to 150 bps);
- the beginning of a liquidity crunch in capital markets that starts to look like the one experienced during the LTCM crisis (10 year swap spreads are - at 70bps - at their highest levels since 2002 and close to the levels that triggered the 1998 LTCM crisis);
- the effective shut down of the CDO and CLO markets as investors risk aversion towards complex derivative instruments - whose official ratings are clearly bogus given the subprime ratings debacle - is sharply up;
- up to 40 LBO deals now in serious trouble (restructured, postponed or cancelled) as the credit crunch is spreading to the leveraged loans and LBO market;
- the overall increasing stresses in a variety of credit markets (”a constipated owl” where “absolutely nothing is moving” is how Bill Gross of Pimco described the effective recent shutdown of the CDO market);
- credit default swap spreads being sharply up;
- the ABX, TABX, LDCX, CMBX, CDX, iTraxx indices all showing rising risk aversion of investors, sharply rising credit default spreads and significant concerns about credit risk in a variety of credit markets (US, Europe and Japan corporate, high yield corporate, commercial real estate, leveraged loans), not just in subprime or in mortgage markets.