Panic is indiscriminate

Federal Reserve Chairman Ben Bernanke said worst-case losses from bad practices in the sub-prime mortgage market will be on the order of $70-100 billion. Once the foreclosures are known and written off, he said, the financial landscape will be little changed; the problem will be “contained.”

For a student of the Great Depression, Bernanke proved himself woefully naïve about the machinery of panics. The Crash of 1929 was fed in large part by investors simply not being able to obtain price information. The ticker was delayed, and people assumed the worst. As prices became known, margin accounts were called and liquidated, fueling more panic.

Today we have the same inability to get accurate pricing for “collateralized debt obligations” (CDOs), which are bundles of loans backed by collateral ranging from credit card receivables to boat loans. Because of greedy mortgage lenders, inadequate ratings agencies, and unsuspecting investors, the most problematic are “mortgage backed obligations” (MBOs), the biggest sub-class of CDOs.

Gridlock in the CDO market caused investors to engage in a flight to safety to government paper (short-term treasury notes and bills). Around the world, the return on 30-day and 90-day government paper rose as much as one percent virtually overnight.

In response, central banks, including the European Central Bank, Bank of Japan, and the U.S. Fed, injected hundreds of billions of new money into their money markets, bringing rates back to desired levels. The persistence of the flight-to-safety move compelled the Fed on Aug. 19 to cut the discount window rate by 50 basis points, extend the term from one day to 30 days, and declare that just about any unimpaired collateral would be accepted.

As of late August, the response to the Fed offer is tepid and consists solely of big banks (that were strong armed into borrowing at the window). But private investors are shunning collateralized debt of any kind, including the grade-A commercial paper (corporate bonds) of major companies. During the week of Aug. 22, the total amount of commercial paper outstanding plunged $90.2 billion — after dropping $91.1 billion the week before.

The contagion of sub-prime CDOs extended to stock markets as well as grade-A commercial paper. It may be irrational for investors to sell stocks unrelated to U.S. sub-prime mortgages, but that is how panic manifests itself. When you don’t know the underlying value of an asset, you suspect its price. Stock index action is a proxy for risk appetite, and risk appetite is clearly on a falling track.

Before you can get a panic and a crash, you need a mania. In this instance, there were two. First, there was a housing bubble fueled by exceptionally low interest rates set by the 1998 Fed in response to the Long Term Capital Management meltdown, itself caused by the mispricing of emerging market debt. In this episode, housing market speculators teamed up with venal mortgage lenders to boost the mortgage market to over $13 trillion — nearly the amount of U.S. GDP.

The second mania was for leverage. Instead of spending one dollar for one dollar’s worth of asset value, with a little discount for potential default, supposedly prudent banks and investment funds paid only a fraction of the asset price, borrowing the rest. As lenders get nervous over underlying asset value, they demand either a higher fraction of the asset price as margin or a new accounting of the asset price, or both.

Will panic lead to crash this time? No one knows. Most observers think the Fed will have to cut interest rates at the next Federal Open Market Committee meeting on Sept. 18, even though such a move will do absolutely nothing to break gridlock in credit markets.

In fact, there is no systemic “credit crunch.” The world is awash in excess savings and, thus, liquidity. However, a credit crunch in a tiny sliver of the market has contaminated all assets.

But the astonishing size of the problem — in the hundreds of billions in each of many market segments — and its unprecedented reach around the globe, will almost certainly force the Fed to act “to restore confidence.”

Although a cut may serve that purpose, it also has the undesirable consequence of restarting the game of musical chairs, a metaphor that even the public now understands: When the music stops again, somebody’s rearend is going to be on the floor.

In a depression… Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved… One of the uses of depression is the exposure of what auditors failed to find.

John Kenneth Galbraith
The Great Crash 1929
(Houghton Mifflin, 1997)

The music will stop when the auditors finish. Ironically, true losses will be small in the grand scheme of things, and the real losses are the opportunity losses as the crisis plays out. Default rates on sub-prime mortgages are at a 10-year high, which may not mean much since so many of these loans were put on at an accelerating pace in the past few years.

Sub-prime mortgages account for approximately 12 to 14 percent of mortgages — about $182 billion. Last year the delinquency rate was 11 percent, so let’s assume some $200 million will default. Let’s say lenders can recapture 40 percent of price from the defaults, reducing the total loss to $120 billion. This is not a big number — only 20 percent higher than the Fed’s estimate — but we won’t know the extent of the losses for another two years. About $400 billion of sub-prime loans face their first interest rate re-set next year, and even more ($500 billion) in 2008.

Speculators who were planning to flip their properties before the re-set will be hit especially hard, not just the hapless first-time buyer who didn’t understand the “adjustable” part of Adjustable Rate Mortgage. Real estate fire sales are going to cut home prices by some unknown percentage. Estimates are all over the place, from 1 percent to 20 percent. And who is to say that only sub-prime mortgages are toxic?

Because it will take so long for auditors to set new prices in housing backed debt, it seems obvious that central banks have to do more to end gridlock in money markets, but exactly what is unclear. Simply cutting overnight rates will do nothing to assure investors that asset-backed paper is safe and desirable. Central banks know this, of course, but they also know that cutting rates is the single most confidence-inspiring thing they can do, even if it doesn’t actually address the real problems.

Enter the auditors (again). We can probably safely assume that everyone from the Fed to the most remote hedge fund is hiring auditors to pore over loan collateral. In the meantime, the consumer is perceived to have stayed optimistic and willing to spend in part because the equity in his house was going up. Until recently, so was his investment in equities in his 401K and pension fund.

It is impossible to measure the “wealth effect,” but it almost certainly exists. If house prices fall, will a housingled recession unfold? Wages and salaries are still rising, and a great deal depends on corporate capital investment (which has been unaccountably low in recent years), so the probability of a recession is not a slam-dunk high number — but it’s probably more than 50 percent.