View Full Version : Greenspan warns subprime woes could spread
Walter Yannis
03-15-07, 19:16
Greenspan warns subprime woes could spread (http://news.yahoo.com/s/nm/20070315/bs_nm/usa_economy_greenspan_dc)
By Ros Krasny
Thu Mar 15, 5:07 PM ET
Former Federal Reserve Chairman Alan Greenspan said on Thursday there was a risk that rising defaults in subprime mortgage markets could spill over into other economic sectors.
In a wide-ranging question-and-answer session at the Futures Industry Association meeting, Greenspan conceded it was "hard to find any such evidence" about spillover from stressed mortgages yet, but: "You can't take 10 percent out of mortgage originations without some impact."
"I'd expect it to -- I'm waiting -- but the spillovers are just not there," he said. Some problems have turned up in collateralized debt markets, Greenspan added.
Greenspan said the housing downturn appeared to stem more from the recent stagnation in housing prices after years of appreciation than from a decline in mortgage quality but said he was not downplaying problems in so-called subprime loans.
Subprime woes were "not a small issue," said the 81-year-old policy kingpin emeritus.
The current problems seemed to result primarily from buyers who had come into lofty housing markets late in the game, Greenspan said, only after huge price run-ups that made homes less affordable.
Default rates in the subprime segment of the U.S. mortgage market have jumped in recent months as the housing industry slowed and prices fell.
At least 20 lenders in the subprime mortgage sector, which serves borrowers with poor credit histories at high interest rates, have gone out of business as a result.
The crisis has triggered broader concerns that the fallout may spread to mainstream lenders and damage the economy.
Greenspan, whose words still move markets even though he vacated the Fed chairmanship more than a year ago, said much of the strength in consumer spending over the past five years could be traced to capital gains, both realized and unrealized, on surging housing prices.
If home prices keep falling, there could be more of an impact on the broader economy's momentum, he indicated. Consumer spending fuels two-thirds of national economic activity.
Greenspan declined to comment specifically on the Fed's current monetary policy or the likely direction of interest rates.
On other issues, Greenspan unleashed a broadside at what he termed "archaic" procedures for settling trades in the huge over-the-counter credit derivatives market.
"I was shocked to find the credit derivatives market, which was working superbly, ends up with the settlement and clearing done with 19th century technology," Greenspan told the futures conference.
"There's an insanity out there that I don't understand," he added. He called on the New York Federal Reserve Bank, which plays a crucial role in the U.S. central bank's financial settlements procedure, to stay involved or "we would face a really dangerous problem."
Greenspan also warned the pending retirement of the baby boom generation would be a "seminal event" for the U.S. economy as costs of entitlement programs rise.
Successive administrations had over-promised benefits to the point where the United States faces a "serious ethical problem," Greenspan said.
Walter Yannis
03-15-07, 19:17
Interesting that Greenspan should hint at the problems in the derivatives market.
Bloodbath coming?
LTCM times ten????
"I was shocked to find the credit derivatives market, which was working superbly, ends up with the settlement and clearing done with 19th century technology," Greenspan told the futures conference.
What Greenspan is talking about is that all underlying securities must 'clear the post' -- something they have in common with many forms of securities and financial instruments, including stocks and bonds; namely, big brokerage houses certainly can run internal books, netting one customer against another, so that only their net position needs to clear the post and go through settlement.
The 'Cincinnati Stock Exchange',[1] e.g., exists as a computer in a closet in Chicago, since options trading -- in this case by the CBOE -- can use more or less automated pairing of the underlying securities. It is cheaper not to pay br, okers when there is no real work to do (the prices on they buy and sell side are predictable), as in closing out options.
[1] Now NSX: http://en.wikipedia.org/wiki/National_Stock_Exchange
Likewise there is a large scale phenomenon, 'disintermediation' which means making money by cutting the exchanges out of some or all of their business, eliminating the proverbial middle man. In effect, the larger brokerage houses maintain their own internal markets, and only use the exchanges for 'risk management' (i.e., a place they can dump if they need to unload a risky position). The 'third market' has grown continuously, with computer matching technology, program trading and such.
Disintermediation is accompanied by a phenomenon called 'paying for order flow' in which the third market offers to pay rather than charge a commission, in order to get orders.
Decilmalisation (removal of the old 1/8ths in stocks) was another factor in this world, read, guaranteed 12 cents commission, was replace by something in hundreths (read, lowering commissions at the exchanges because of competitive pressures from disintermediation). The fear, of course, is the middleman's fear of being cut out of the deal. Brokers make money both ways, just like real estate brokers, though a fast-moving bull market is certainly better.
*BUT* there is the curious circumstance that the big exchanges (New York, AMEX, the Regionals like Chicago) continue to exist, even in this age of hackneyed information. What gives? What gives is in effect a government franchise -- exchanges are convenient points for 'government' management, er, regulation, of securities, and stocks and bonds -- instead of being traded in some new computer system put together with some Linus Torvalds of Wall Street. The law is indeed arcane, and what the law mostly says is that the paid-per-member guilds that run the exchanges get a certain (decreasing, less valuable) cut. It's like toll booths -- not metaphysically necessary, but a political fact of life, and part of the landscape since, oh, forever.
What is funny, of course, is that all this must be quite as well known to Alan Greenspan, as it is common knowledge in the securities industry. What, Greenspan hasn't heard of trend towards disintermediation and efficiency of market (commissions) that's been going on since about 1985, including his entire tenure as the Fed-man? He's shocked, shocked to find that stock markets have an arcane clearing process, and that brokerage houses aren't using every option legal on God's green earth and quite a few that aren't to circumvent it? How droll.
Blaming the derivatives mess on market dysfunction can only mean one things -- someone has plans to cut out the markets and grab the commission pie for their buddies and Sir Alan knows it. The attempts have been going on since the 80s. They must just be waiting for the plum to fall this time round. Now, it wouldn't be Bernie whatever his name is would it?
ADDED:
http://www.isda.org/educat/faqs.html#23
23. What is a credit derivative?
A credit derivative is a privately negotiated agreement that explicitly shifts credit risk from one party to the other.
24. Product description: Credit default swaps
A credit default swap is a credit derivative contract in which one party (protection buyer) pays an periodic fee to another party (protection seller) in return for compensation for default (or similar credit event) by a reference entity. The reference entity is not a party to the credit default swap. It is not necessary for the protection buyer to suffer an actual loss to be eligible for compensation if a credit event occurs.
Now I wonder why Big Al is thinking about those? When's the last time you bought some protection from a guy named Al?
PPS:
Didn't take long (just search "credit derivatives" and a buzz work like disintermediation) to bring it up:
http://jobfunctions.bnet.com/whitepaper.aspx?docid=73753
Credit Derivatives: Opportunities For Exchanges And Clearinghouses
Overview: Credit derivatives promise to revolutionise finance by making credit risk measurable and truly manageable. However, unlike interest rate, currency and equity derivatives and despite rapid growth in recent years, credit derivatives remain, so far, a niche over-the-counter market, barely scratching the surface of their opportunity space. To achieve their promise, credit derivative markets need to develop organised exchanges and clearinghouses comparable to those that support more mature financial contracts. Well designed exchanges and clearinghouses can provide credit derivative markets with the liquidity, transparency and security of settlement they need to overcome the barriers to growth they are facing. The article investigates some of the hurdles that need to be overcome for the further development of the credit derivatives market.
So Al's answer to our crisis? Well, markets are great, so if the subprimes go into default, LET'S BET ON IT. Speculation is IT, man. Let's go build an efficient market solution. Hallelujah we're gonna be saved by derivatives to manage the risk of derivatives that manage the risk of well I forget what.
http://www.finance.ox.ac.uk/file_links/finecon_papers/2001fe01.pdf [PDF]
Abstract:
The credit derivatves market provides a liquid but opaque forum for
secondary market trading of banking assets. I show that when entrepeneurs
rely upon certification of bank debt to obtain cheap bond market finance,
the existence of a credit derivatives market may cause them to issue sub-
investment grade bonds instead, and to engage in second-best behaviour.
Credit derivatives therefore cause disintermediation and thus
reduce welfare. I argue that this effect can be most effectively countered
by the introduction of reporting requirements for credit derivatives.
[Example, real estate debt risk: --ed.]
I examine in this paper the consequences of this market for
funding and investment decisions in the real sector. I consider
an economy in which entrepeneurs raise debt finance to run one of two
projects and I show that in the absence of credit derivatives, some
borrowers will employ bank debt to signal their intention to run a
first best project. I argue taht banks whose assest are highly con-
centrated in a particular sector will exhibit risk aversion and hence
may trade with a less concentrated counterparty in the credit derivatives
market in order to diversify their portfolios, as above. When a bank
is sufficiently risk-averse towards a particular asset, it will entirely
cover its exposure to that asset. For the issuer of such an asset,
the credit derivatives market will destroy the signalling value of
bank debt and he will instead issue junk bonds and run a second-best
project. Although trades in a secondary market for bank debt
will be welfare-increasing, the existence of the market will,
in that it alters the decisions of corporations and reduces the volume
of bank debt, be welfare-reducing.
Walter Yannis
03-16-07, 02:17
Now I wonder why Big Al is thinking about those? When's the last time you bought some protection from a guy named Al?
Well, the problem is that even though Big Al has a good rep for fighting inflation, he just exchanged the surreptitious theft that inflation entails for the even more subtle theft of hiding credit risks.
I have come to believe that many of our problems can be attributed to bad accounting. We just don't know how to book expenses.
Big Al did all sorts of stuff to encourage risk taking - driving up market housing values by artificially low interest rates on the Fed side combined with the income tax deduction for second mortgages is one of the biggies.
But there were others. Credit card companies took huge spreads on interest rates - the most profitable cards were the ones they issued in mass mailings to the uncreditworthy. How many "pre approved" cards for thousands of dollars have I seen in the past 15 years?
GM Finance was another great one for gunning car sales by taking on all sorts of credit risk, and GM Finance didn't stop with cars.
The point I'm trying to make is that risk is real, it has real economic value, and just like the laws of physics require the conservation of energy so too the laws of economics require that the value of that additional risk be expressed some way.
As it is we've all been engaged in what amounts of a decades-long attempt to ignore the economic reality of risk, thinking that we can make it disappear by stuffing it all in the incorporation certifcate of some Virgin Islands offshore company.
But that's to mistake a legal fiction for economic reality. The truth is that the value of that additional risk has been building up for the longest time now, and we've built a house of cards.
Big Al was encouraged by the strong productivity gains caused by leaps in IT science to hide most of it, but now that productivity gains are grinding to a halt the reckoning suddenly seems closer.
The derivatives market is where that credit risk is exchanged. That market is almost completely unregulated and therefore opaque. Nobody really knows what's there beyond a handful of folks working in the Wall Street investment banks that run the big derivatives traders.
My prediction: there will be a meltdown in the derivatives market and everybody will act surprised.
Don't believe the bastards. They know it's coming, but they're shutting up about it so that they can put off a little more of that risk on their favorite suckers, I mean customers.
[URL="http://news.yahoo.com/s/nm/20070315/bs_nm/usa_economy_greenspan_dc"]
"I was shocked to find the credit derivatives market, which was working superbly, ends up with the settlement and clearing done with 19th century technology," Greenspan told the futures conference.[/B]
I think what he is talking about here is FTDs or Failure To Deliver. Since it has become part of the freedom of information act, I highly doubt Greenspan can claim ignorance of them.
Basically, it’s an IOU for brokerage houses to keep the flow of trades going while the good folks at Sachs and Morgan dig up the actual paper certificates. It was grand fathered in during the regulation era of the 30’s.
Basically why it has gathered attention was that smaller companies were complaining about them. Here’s one way they have worked. A brokerage house pushes stock of a small company, selling more stock than the company has issued in the form of these FTDs. Knowing this will drive down the price of the stock they in turn sell short on the company, nice, huh?
Anyway no one knows exactly how many of these FTDs are out there. Here’s a good tutorial.
http://www.businessjive.com/nss/darkside.html
Blond Knight
03-18-07, 08:36
A good article from Asia Times that addresses this problem:
^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^
An excerpt:
Mar 17, 2007
Page 1 of 3
Why the subprime bust will spread
By Henry C K Liu
Years ago when the US debt bubble spread over to the housing sector, warnings from many quarters about the systemic danger of subprime mortgages were 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 Reserve 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 United States' economic fundamentals are sound in the face of a jittery market. Days before being delisted from the New York Stock Exchange, shares of the collapsed New Century, a distressed subprime mortgage lender, were recommended by a major Wall Street brokerage firm as a "buy". That firm is now under criminal and regulatory investigation.
On the pages of Asia Times Online over the past two years, I have tried to put forth the rationale for the inevitability of a US housing bubble burst, pointing out reasons that the resultant financial meltdown will be much more widespread and severe than has been generally acknowledged.
Full Article: http://www.atimes.com/atimes/Global_Economy/IC17Dj01.html
Willie smells a rat too...
http://financialsense.com/fsu/editorials/willie/2007/0314.html
...
A preface is in order, to honor Sir Alan Greenspan. The housing bust and the mortgage finance debacle have his signature on them. So far he is still revered, for some odd reason, probably basic ignorance. Some called Clinton the “Teflon Man” which more deservedly belongs to Greenspan. Heck, they both earned the title; they can wear it with the ignominy it so justly is associated with.
GREENSPAN SIGNATURE
The current mess of mortgage defaults and foreclosures testifies to the venerable and highly acclaimed serial bubble inflation engineer Greenspan’s leadership and counsel as destructive in high order. Alan must be shuddering and cringing at the extreme damage to banking balance sheets, the spate of lending institution collapses, and the contagion within banks. He urged millions of US homeowners to rush into adjustable rate mortgages, so as to reduce their monthly costs. Here is an actual quote from Greenspan, extolling the virtues (vultures) of innovative mortgages. IT IS A SHOCKER, from a modern day John Law, who assisted in the transformation of the USEconomy into a giant hedge fund. Its foundation sits atop bubbles. Remember the two concepts Alan loves the most. That “innovation” is just another misleading term for broadened leverage to ramp a particular market. That “productivity” refers to more computing power for program stock & bond & derivatives trading (to earn fees), to displace workers (ending employer labor costs & fringe benefits) in the age of the great financial engineering miracle. Or is it a miraculous destruction? Would Sir Alan recall his words? Would he be proud of them? Methinks no and no. Why was he knighted by the Queen? Could it be because he helped bring down the US challenger to Old Europe? The lost US manufacturing base is a direct consequence of chronic inflation topped off by Greenspan policies. The housing bubble is one of Greenspan’s more direct accomplishments. Decide for yourself.
“Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants… With these advances in technology, lenders have taken advantage of credit scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers… Where once more marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending,… fostering constructive innovation that is both responsive to market demand and beneficial to consumers.”
-- Alan Greenspan, April 2005
...
Greenspan was responsible for creating the mess, now he leads interference for reactive policy change. He has talked about a recession likelihood, but continues to deny a spillover of the housing debacle into the real economy. More accurately, he awaits the spillover. One should regard the Greenspan role as carefully orchestrated, not by any means accidental. He has created the psychological backdrop perfectly for Bernanke to cut official interest rates. Ben needed a shock to stocks, a change in sentiment and outlook. He got it.
Walter Yannis
03-20-07, 20:26
Willie smells a rat too...
http://financialsense.com/fsu/editorials/willie/2007/0314.html
Willie argues in effect that the US Government CPI is a sham and is actually about six percentage points below its true level. Ygg says something similar.
Here's what I don't get about that: if banks understand this (and presumably they do), then they wouldn't lend money at 6% for 30 years, because if the real CPI is 10% then they're bleeding money at 4% in real terms.
If the CPI is really such boloney, then why do banks eat such losses?
I understand that some of them are speculating elsewhere, but still, that's a helluva margin to cover, no?
Willie argues in effect that the US Government CPI is a sham and is actually about six percentage points below its true level. Ygg says something similar.
Here's what I don't get about that: if banks understand this (and presumably they do), then they wouldn't lend money at 6% for 30 years, because if the real CPI is 10% then they're bleeding money at 4% in real terms.
If the CPI is really such boloney, then why do banks eat such losses?
I understand that some of them are speculating elsewhere, but still, that's a helluva margin to cover, no?
Yer certainly on to something Walter -- I no more believe in negative real interest rates than you do (except temporarily, way off in the future where they denote differences of opinion on possible risks, in inverted yield curves distorted by derivatives and speculation -- where arbitrage and the carry trade promptly fix them).
Here's my guess -- these are aggregate figures that represent averages over very two different markets -- the market in consumer goods and the market in securities. There would certainly be a paradox in terms of free trade, because the 'dollars abroad' would represent claims on local assets, and goods could freely flow to balance it all out in the classic IS-LM model way, with at most a liquidity trap (0 interest rate).
But markets aren't free for two reasons:
-- China (and to a lesser extent Japan) have central banks that behave in a way that defies all market logic, in pursuit of, presumably, nationalist goals.
-- our fiat money is marked 'legal tender' which means that when someone walks in with one of these debt coupons, they are purchasing on an equal footing (by the same sort of law that governs China and it ain't free market), with someone who walks in with silver dimes. The absence of discounting for U.S. bonds is the same sort of effect as rent controls or minimum wage -- a 'market imperfection'. 'Legal tender' for *debt* means 'almost, but not quite, entirely unlike money'.
In theory, I should be able to use my fiat money to outbid hungry people locally and buy truckloads of carrots, say, to ship off to China, where equally hungry people only with abundant dollars will snap them up, and make enough money doing it to bring the markets all back in balance and interest rates in line with the two different inflation rates in both countries -- a certain amount of this of course occurs in building materials, college educations, and domestic land purchase, but not nearly enough to stem the tide of McDonald's happy meal toys and cheap electronics. If inflation rates differ, I should bring them back in line by capital (investment) flows, to take advantage of the difference between real and nominal interest -- and if I don't, I get killed by arbitrage in the foreign exchange market (and by the profits of carrot exporters) -- so I'd better do what the market tells me. Only it doesn't these days hey?
The ability to sustain vastly different nominal interest rates in two different countries -- *with* substantial trading between them -- is not possible in the classical theory. This is the problem of the 'open economy' (Belgium in the EU, say, vs. US and its trading partners) in which a small country with very substantial trade has fewer Keynesian 'levers' (fiscal and monetary policy) -- bad multipliers -- so they basically get screwed by trade deficits. The US has moved from a relatively self-sufficient Keynesian situation to one in which independent pursuit of policy, vis-a-vis inflation, unemployment, trade deficits -- *should* be harder. There is not enough independence in the equations, specifically the multipliers suck and diminishing returns brings my game to a halt whenever I get exhausted with the shoe-leather costs (I'm lazy too).
*BUT* we defy that prediction of classical Keynesianism too. China and Japan have been 'letting us get away with it'. In particular, the classical analysis avoids (1) petro-dollars, which was the deal cut by Carter in the 70s to trade OPEC oil for 25-30 year CDs deposited at Citibank and ilk [basically, the Fed shareholders] -- tidy interest and F-whatever planes for the Arabs, and US gets long term backing for fractional banking. (2) the new sino-dollar proposal, which no one has talked about, that has China using its 1 Trillion dollars of US debt as backing for a *Chinese pyramid scheme* -- mutual funds for Chinese investors, who will be forced to do the Asian saving thing with one vehicle available, speculating on mutual funds that have as their backing asset the mighty productivity of American labour. But who cares about the worth of an underlying asset in a bubble? Tulips were pretty wimpy too, but *speculation* in Tulips by Asian speculators desperate to retire -- now there's a bubble. We replace the Mighty Arab-backed Fed with the Mighty Chinese Bond Fund. Damn -- we just exported the Fed in one giant paper haul. Now the claims on American assets are not in New York, but half in Beijing. Not that it hasn't been done before. Before New York, there was London.
This is a clever idea, to export our asset bubble to China, where the population gets a spending boom. Time to share the psychic benefits of feel-good Americanism somewhere they actually have productivity and need to consume things to do more than stay alive. The Chinese have decided what they want to buy with their USD Trillion, and what they want is the US 1990s and 2000s for themselves. So as long as they don't regret this, that debt *never* comes home to roost. We of course get off the debt hook for now -- except the phrase 'we owe it to ourselves' gets expanded to include a billion more of 'us' in the US-China coprosperity sphere, and there is no guarantee that we will always be on the top 20% of the whole pie. The economies get inter-twined (not unlike the combined white/black welfare economy, with internal fiscal transfers representing 'entitlements'), and must be managed jointly. A billion retiree asian bondholders will have something to say about how we all manage 'our' assets in 'our' mutual funds. It's not just your grandfather's social security -- it's Mao's grandchildrens' too.
Funny how the ultimate solution to the 25-30 petrodollar problem was to substitute commodity backed fractional reserve banking for labour-backed fractional reserve banking. I suspect it will take a while for academia to wake up and smell the Asians. Took me to the end of the essay I posted, and an OMG and a WTF or two.
Anyway, with apologies to what the old lady retorted to Bertrand Russell, 'it's asset pyramids all the way down' (not turtles). Greenspan has told us the future is a new binge of speculation on creditworthiness of mortgages to replace the broken, more direct asset bubble, and this will be backed up, we learn, by willing speculators held in servile bondage by the Chinese regime, with a gradual, managed swap of Asian slaves for American ones, in the classic boil the frog move -- see Hans' video. So that's settled then. No crisis (sorry Walter), just one hell of a ball and chain. Ends in a whimper, unfortunately. Americans -- they're the new Blacks.
But back to interest rates -- it's a combination of two very different economies (one for normal people and another for the international proles), denominated in two seperate currencies -- the internal commodity-dollar and mutual funds, bonds etc. Mostly, these markets are time separated -- permanent long term 'really negative' yield curve. Inflation and a balanced trade deficit -- and implied collapse of bonds, housing, etc. is just around the corner. Only tomorrow never comes.
The economies of the brave new worlds (a class division replacing the old borders division) are kept apart by making sure the big world of consumers does not interact with the big world of asset bubbles -- much as trade barriers, or at least irrelevant quantities of flowing goods, were needed to keep 'nations' seperate, i.e., able to determine fiscal and monetary policy as sovereign entities, rather than face the classic 'internal' problem -- Chicago can't set a sovereign local fiscal or monetary policy because (1) it's full of blacks who don't make anything worth buying and have overvalued houses in neighborhoods no one wants to move to and (2) trade flows through I-90 and I-94 are significant and the borders open. America just became Chicago. Oh yeah, Chicago was never sovereign in the sense of being able to print money, fiat or otherwise, and now America isn't either.
Summary: Sucks to be globalised. But it does explain negative interest rates.
Walter Yannis
03-20-07, 23:34
Summary: Sucks to be globalised. But it does explain negative interest rates.
Globalization might explain the phenomenon for the near to mid-term as you say, but IMHO it isn't a robust explanation within the long-term context of 30-year 6% mortgages under a spread calculated to the 30-year USGBond.
Nobody in their right mind would place a long term bet like that if he didn't believe the numbers.
And this brings me to what might be the scariest thought of all: what if (1) the CPI really is boloney, but that (2) the HSBCs, Citibanks, and BoA's of the world actually believe in the CPI? :eek:
In other words, what if they're completely deluded? What if they bought their own propaganda??
I'm not saying that what Ygg, for example, says about the CPI is wrong. In fact, his arguments seem strong to this amateur. But that just makes the possibility that our entire financial system from the Fed on down is based on delusional thinking. And why not? There are plenty of historical precedents for the financial professionals losing touch with reality.
Which is why I think a bang is more likely then a wimper.:D
Here's what I don't get about that: if banks understand this (and presumably they do), then they wouldn't lend money at 6% for 30 years, because if the real CPI is 10% then they're bleeding money at 4% in real terms.
For one thing, you make the mistake thinking that banks think long term. If they were thinking long term why would they have given out so many loans lately to those who could obviously not afford the homes they were buying and could only appear to afford them because of low teaser rate mortgages. It worked for a while but only because home prices were going up so fast that even if the mortgage holder defaulted the bank got back a house that was worth more then the mortgage, but it was obvious that there was no way such appreciation was going to continue since wages were not going up fast enough to pay for these more expensive homes. So what the banks were doing was thinking short term on a long term investment, they were getting as much fees out of the borrower today as possible and not worrying about what happens when the bubble deflates.
History is full of examples of banks thinking short term on long term investments. And its even worse these days when the banks are corporations and are judged on today’s stock price and this quarters dividend and when the executives have a golden parachute standing by in case things go bad.
Walter Yannis
03-21-07, 07:02
For one thing, you make the mistake thinking that banks think long term. If they were thinking long term why would they have given out so many loans lately to those who could obviously not afford the homes they were buying and could only appear to afford them because of low teaser rate mortgages. SNIP History is full of examples of banks thinking short term on long term investments. And its even worse these days when the banks are corporations and are judged on today’s stock price and this quarters dividend and when the executives have a golden parachute standing by in case things go bad.
You make a good point, but I suspect you overstate the case somewhat.
The banks put off a good deal of the risk on those subprime loans. That is, they sold these high risk loans - lots of them floating rate - and then sold them as bonds and/or went to the derivatives market for various kinds of counter bets.
Somebody someplace thought that the bonds backed by those mortgages had a discounted value of X over the life of the underlying obligations. The benchmark in judging that is the "zero-risk" USTBond.
Ultimately, it's all about evaluating risks. The folks who bought those bonds and who took the opposite position on the derivatives market think about these things.
The reality of the CPI is a major factor in evaluating those risks.
I can't avoid the conclusion that the people in the markets who evaluate these risks at bottom trust the figure.
I am more than willing to be set straight on that.
I can't avoid the conclusion that the people in the markets who evaluate these risks at bottom trust the figure.
I am more than willing to be set straight on that.
I agree, a lot of people have based their investments on these numbers and it has paid off for them. However just because a lot of people believe something does not mean that they are right, bubbles are created when lots of people believes something that is wrong.
But even if an individual in the market did not trust the numbers they are forced to follow the herd. For example if a bank thought in 2005 that there was a housing bubble and cut back on housing loans, in 2006 its profits, its dividends, its stock price would have been hammered and the market would said that it was a failure. So even if the bank president thought that giving out “liar loans” was a bad idea, if he had not jumped on the bandwagon he would be out of a job since the market would have said he was not “hitting the numbers”.
Also in the market there is a feeling that if things go bad they can sell their investment before things get worse or they can ride it out or in the case of the housing bonds, they can send them back to the mortgage company that originated them and make them buy it back. Not wanting to think about that there might not be a buyer for the bad bonds or that the mortgage originator has no assets to buy the bonds back since they are nothing but a leased office and a shell company. There is always a feeling among the smart ones that they won’t get caught in the down side and it will be some other guy who gets caught holding the bag
Walter Yannis
03-21-07, 07:34
[=Grapple;8612]I agree, a lot of people have based their investments on these numbers and it has paid off for them. However just because a lot of people believe something does not mean that they are right, bubbles are created when lots of people believes something that is wrong.
Just to be clear, I'm not saying the government CPI is right, I'm just saying that the market professionals seem to believe it.
But even if an individual in the market did not trust the numbers they are forced to follow the herd. For example if a bank thought in 2005 that there was a housing bubble and cut back on housing loans, in 2006 its profits, its dividends, its stock price would have been hammered and the market would said that it was a failure. So even if the bank president thought that giving out “liar loans” was a bad idea, if he had not jumped on the bandwagon he would be out of a job since the market would have said he was not “hitting the numbers”.
Yes, I see. That's an excellent point.
Also in the market there is a feeling that if things go bad they can sell their investment before things get worse or they can ride it out or in the case of the housing bonds, they can send them back to the mortgage company that originated them and make them buy it back. Not wanting to think about that there might not be a buyer for the bad bonds or that the mortgage originator has no assets to buy the bonds back since they are nothing but a leased office and a shell company. There is always a feeling among the smart ones that they won’t get caught in the down side and it will be some other guy who gets caught holding the bag.
Another good point.
So, would it be fair to say that what we have is a market that is deluded enough to believe the Fed's propaganda and so shortsighted it can't see beyond even a fraction of the time horizons of its financial committments?
Could this be something approaching a perfect storm?
You make a good point, but I suspect you overstate the case somewhat.
The banks put off a good deal of the risk on those subprime loans. That is, they sold these high risk loans - lots of them floating rate - and then sold them as bonds and/or went to the derivatives market for various kinds of counter bets.
Somebody someplace thought that the bonds backed by those mortgages had a discounted value of X over the life of the underlying obligations. The benchmark in judging that is the "zero-risk" USTBond.
Ultimately, it's all about evaluating risks. The folks who bought those bonds and who took the opposite position on the derivatives market think about these things.
The reality of the CPI is a major factor in evaluating those risks.
I can't avoid the conclusion that the people in the markets who evaluate these risks at bottom trust the figure.
I am more than willing to be set straight on that.
I'm well aware I haven't completely answered your question -- I had to go help my 12-year old do his homework and my post was overlong anyway. :)
OK -- back to it:
First, a metacomment on institutional behaviour (good discussion above). Willie started out as a stats analyst on the inside and got canned. Presumably, if his claims are true, this is a rather direct way of saying the big guys don't want to hear it. But it is not as simple as Cassandra. The models used are more complex than the simple ones discussed in public -- Ron Unz made 100 Million USD selling derivatives models to banks, and in the last two decades it's been statisticians and ex-theoretical physicists who have built the models. Something like the CPI is likely to turn up as a fudge variable or free parameter, but not necessarily 'something you believe'. You believe models and predictions, not derived data analysis results that are given to you.
So Willie woke up one day and smelled the stench, but no one cared. Your argument goes like 'the model is wrong and everyone knows it; therefore they should act on that knowledge; this proves they really are irrational' -- they do act on the knowledge they have -- and it isn't the CPI they believe. They use a different model. Do those models have a realistic CPI component? Unknown. No one with brains takes the government at face value, but Willie got fired. Is that because they bought themselves a better Willie? Or is Morgan filled with typical middle managers who will try to jump ship when the crash becomes apparent to them -- except for the suckers who get fleeced by those who retire early, which is the right timing. Who knows?
Imagine a casino where the model is broken -- the house *doesn't* have an advantage. Sure, a lot of independent gamblers (Forex, bond pits) show up and try to beat the house -- almost won in summer 2005 but the Japs bailed the US out -- but they still lose. A couple problems: they don't have the capital to break the bank, and the central bank can pull out its plungers and bluff pretty much all the way down. Finally, behind door number two is an 850-pound gorilla from Asia -- several of them -- that would be happy to eat you. Still, cartels are unstable -- why doesn't one of the institutions cheat? Could they make money doing it?
Here's my next reason: the institutions and a lot of the big investors and insiders have something to hide -- 1. their derivatives books 2. their shenanigans in the carry trade. For the latter, read Willie's old articles and think Whitewater. Think options trading. The insiders and pols put bets on the interest rate movement. These became self-fulfilling predictions in the sense that large institutions acquired very powerful motives to 'make it so' -- to not unwind, motives that come from the political interests of their patrons and shills, not to mention the likelihood of a few of them, of going first broke then to jail. This adds a bit of punch to the 'herd instinct' so correctly pointed out above.
Willie by the way is a stats guy as I said:
http://www.goldenjackass.com/jwarticles.html
In economics he follows Richebaecher ( http://richebacher.com/ )
Anyway, summarising so far:
1. I proposed market segmentation in the NWO, with the consumer market, as the classic open economy problem, in which sovereign use of economic levers becomes ineffective and futile. There is no paradox in saying 'how can T-bills in the US be so high when peasants are starving in China?' and re-partitioning the economy horizontally (by class) instead of vertically (by nation), which is the NWO/4th International in a nutshell, doesn't substantially change matters. The peasants can experience inflation in food while T-bills remain rock solid, essentially forever. (There are still problems and this isn't a complete explanation). There is no paradox in saying 'why are the peasants in Detroit starving' while T-bills perk along at rates that would be, allegedly, negative, compared to the vast opportunities for managing peasants in Detroit. But all the evidence is the slum lords are balking at this opportunity, and Detroit is the new Third World.
2. There are powerful institutional motives -- bad models, derivative books, political corruption, as well as the advantages of power and a large cache to bet from, combined with herd mentality. This has existed for some time -- big institutions have flawed models because of their size. They have two reasons to never beat the market: they are too big to find relevant opportunities. Small guys can triple their income, but big guys find it harder. Where can Bill Gates find an investment that will turn his 50 billion into 150? Second, it is risky for mutual funds to underfund the market, so they buy market baskets and index funds precisely to avoid downside risk. Smaller players are more risk tolerant. But it is still hard to turn an aircraft carrier or to attack one. The small guys who are 'right' don't have better than even odds, even in the best opportunity (as, August 2005).
3. The CPI is false and damnably so -- I go to the store and buy pretty much the same market basket every week. 15 years ago, that basket averaged $1 per item. Today, it is around $3.50. As recently as 5 years ago it was $2.00. The CPI that I see 10-15% per annum for the last few years. Anyone with eyes knows this. But I am not the 'average consumer' of the aggregate model -- but then neither I nor the central banks and banking sector really care about that hypothetical individual, who summarises a naive model of a complex economy that only undergraduates use anyway.
But enough -- you and I both agree that the investment community knows all this, and human nature is such that cartels like the Money Trust, whatever their motives and strengths eventually get broken. Someone finds a way to cheat, or makes a miscalculation, or a famine or peasant revolt or bad outcome for a war breaks the house, and we get a new deal of the cards. Happens several times a century for the past 500 years. Why hasn't it? It's like Holland betting against the North Sea. In the long run they lose.
Perhaps we should think of the Fed as a tax farming operation. The gummint says 'The peasants shall henceforth pay $10,000 in taxes.' and the Fed say 'It is good.' takes their cut and puts the T-bill on the block. Someone buys it as an investment and one day it matures and $10,000 in taxes are collected, and the debt is paid (to the bond holder). The tax can be in the form of inflation or actual tax. To the Fed it looks like an entitlement and to the bondholder it looks like a welfare coupon they purchased, exchangeable for food, housing and what not.
In that world, the bondholder is certainly in the same 'market segment' as slum landlords --probably is one. The real problem is not institutional behaviour (which is not paradoxical), but the risk behaviour of the slum lords and T-bill holders of the world who *aren't* in China. Why doesn't he take more risk? T-bills are risk free (the hypothesis), CPI makes it so he practically gets paid for zero risk. Foreclosed houses just dropped to under $20,000 in the Detroit slums with no takers, and the gummint is printing money and dropping it from helicopters, backed by the Asians. Why doesn't Mr Rich White Republican make his move?
Maybe the situation is so volatile that our risk premiums have risk premiums. Volatility (beta), or risk, is just a parameter like mean or expected earnings. Betas have uncertainties too. When derivatives and leverage becomes important, as it *has*, there is a second risk premium to be paid on the model. It may be that the T-bill is not zero risk -- but negative risk measured against all non-governmental investment opportunities. That is, if you have to bet in a volatile situation you bet on the taxing authority with the army. This opens a gap (the volatility of the volatility used in the models) which is basically model uncertainty. The wages of speculation is interest payments.
So, summarising my argument and without the political and social commentary and motivational speeches: risk management is done via stats and models, usually on a 'regret minimisation' (game playing) basis. The usual procedures and entry-level models are based on least squares or the 'general linear model' and play off the fact that means and variance alone characterise many real world distributions. That is, least squares gives an *efficient* and *unbiased* estimate of the true distribution, provided the underlying distributes are roughly known and not too skewed, and these estimates get better and better for more frequent trials, broader coverage, etc. Let's say actuaries know what they are doing and can make money at it.
But (1) the CPI is not what they use -- they use sector by sector models that don't hide the inflation the poor are seeing. (2) risk management can't be restricted to or synonymous with 'spread' (beta) of the distribution. That's indeed part of the risk of missing the mean with your estimator or predictor, but not all of it. Measurement error and model error and just plain old 'didn't think of that' censoring can get you too. In a highly volatile situation, the *models are bad*.
One can argue that the market is better than any conceivable model (i.e., someone will figure out how to game the people with bad models and win, even if they aren't 'smart' about statistics and maybe especially if they aren't). But that can take rather a long time, and betting on perfectly efficient information flow is like betting on the inevitable progress of science -- good but not perfect as bets go. The unexpected still happens. Sometimes the transistor or DNA *doesn't* show up on schedule, and the very long run of technical efficiency ends up being shorter than the short run of grab it and go. :)
I think the real question you want to ask is -- not do the bond markets use the CPI in their risk analysis, but does their calculation of the housing sector contribution to the CPI contain a mistake? 'Cuz that would be fun for investors.
Willie's take two years ago: http://www.gold-eagle.com/editorials_05/willie020105.html
THE HOUSING MARKET
Over 30% of the weight in the CPI is devoted to rental prices. What an absurdity. Who cares the motive for such incompetence, misrepresentation, and distortion? It s what it is. The tide is surely coming in to provide ridiculously magnificent mortgage funds for potential homeowners. Fanny Mae, Freddy Mac, and other federal mortgage pools have made the application process a slam dunk. Low income, low asset ratio, complications from inspection, money under the table for closing costs, not a problem. Come on down! Regardless of loan quality, Fanny will enable a portfolio recycle of funds, origination points being earned. No distinction is made for new construction or existing homes. The ratio of housing value to rental income is an excellent indication of price-earnings ratio commonly reported to stocks. In the case of housing, the value-to-income ratio is at least 5% above the previous bubble peak in 1989. Rental prices are way down on a relative basis. Homeowners who chase a property for purchase leave the rentals wanting. Deals to rent a house are commonplace. The result of the multi-year housing boom which began in 1994 or 1995 has been to greatly suppress rental prices. A primary beneficiary in the statistics world has been the CPI.
So if the CPI were used to turn nominal interest into real interest by simple subtraction, two basic mistakes would be made: (1) hidden costs of mortgage lending would be overlooked, which are not economically expressed due to accounting flaws in the next best opportunity, renting, causing a CPI understatement, and (2) hedonic correction for technology is a farce, and there is no real economic efficiency because we have Word 2000 instead of Word 97 on our desk tops. The people who bought last year's tech f*cked up big time and will pay in the end, or their bagholders, heirs, and assigns will.
I think the market is on to the first possibility now, and the chance to lock in that gain is over now the cat's out of the bag. :) As for the second, I don't think the pointy heads know how to deal with it -- look at the tech sector for solid performance on a win-win capital investment in technology grows the whole pie play. Boo, yeah. Look at Motorola's or ATandT's stock for confirmation of this. Tech is on such thin margins now it's hard to make money doing *anything*. I think the investment has clearly overshot the opportunities and all the tech companies are going to pull back and look for efficiency plays--layoffs, outsourcing, dropping divisions, sales of under performing business units. The buy ups of new tech are happening though, but I think the big boys will get that wrong and buy into failed or obsolete paradigms. In fact, I'm betting the future of OD on it. :)
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