Bubble. Correction. Credit Crisis… Recession? From Main Street to Wall Street and Back Again…
February 10, 2008
As situation diffuses everywhere and asunder, I though it might be interesting to collate a few notes, gathered from mainstream press reports, on the stages of the current global credit crisis and the impending recession…
1. Dot.com crash (2001): The popular story – after the terrorist attacks and the fall out of the dot.com bubble, risk wary investors redirect their capital into something secure and substantial – housing: ‘There’s no investment as quite as safe as houses’! The shift is assisted by an historic FRB interest rate cuts. Based on a classic model of how monetary policy can be worked to produce macroeconomic stability, Alan Greenspan sustains liquidity in the money supply by aggressively lowering the cost of borrowing.
2. Housing bubble (2001-2005): U.S. real estate undergoes an extraordinary acceleration leading to a ‘speculative housing frenzy’, part of a worldwide rise in real estate prices that The Economist has famously called “the biggest bubble in history”[i]. Defying sound economic expectations, the price of real estate rises “more in real terms [between 1997 and 2002] than in any previous five-year period since 1945”[ii]. The median home price surges from $177,000 in Feb 2001, to $276,000 in June 2006.[iii] A steep increase in home equity creates more than $5 trillion in wealth a five year period, the equivalent of $70,000 per average family of four. [iv] Through various ‘cash out’ refinancing programs and other novel home financing products, U.S. homeowners treat their houses like ATMs. They converted inflating home equity into immediate spending money, pulling over 700 billion dollars (roughly 5% of the GDP in 2004 alone[v]) out of their homes. Real estate’s biggest bull, David Lereah, chief economist at the National Association of Realtors NAR, boldly claims that real estate is “the only sector propping up the economy and keeping it from a full-blown free fall” [vi].
3. Housing correction (mid 2005 –ongoing): The peak of the boom is the middle of 2005. Through the end of the year public commentary remains reassuringly optimistic but within a matter of months trading volumes in real estate have begun to slow, stagnate and then to decline. Word of a bubble, which had previously remained within the parley of professional economists and elite commentators, spills into the public at large. A Wikipedia entry titled ‘United States housing bubble’ appears in May. In July, only 23% of Americans polled by Gallup are familiar with the term ‘housing bubble’, but a year later the figure has jumped to 40%.[vii] By August, Robert Toll of Toll Brothers – “the nation’s premier builder of McMansions”[viii] – is publicly stating that the downturn was unlike anything he’s every seen. In Jan 2006 the buzzword is ‘soft landing’[ix] indicating a general acceptance that the market is indeed cooling, but betraying a widespread hope that things will slow without prices collapsing. It’s the beginning of a ‘market correction’ for those, like Ben Bernanke, who prefer not to use the word ‘pop’.[x]
4. Subprime mortgage crisis (end 2006-ongoing): At the tail end of 2006, default rates shoot up in segment of the mortgage market called the ‘subprime’ that has received little attention in main stream reporting. The subprime is a class of borrowers with ‘blemished credit records’. These homeowners have been “exposed to the multi-featured, exotic, exploding, non-traditional – whatever the name you have for them”[xi] mortgage products. Alternative credit products typified by the ‘option adjustable rate mortgages’ (ARMs), are hit with bad press. (A 2/28 ARM signifies that the payment schedule is set for two years at a low interest rate, after which payments and interest will fluctuate for the remaining twenty eight years of the loan.) ARMs are openly condemned as “the riskiest and most complicated home loan product ever created”[xii]. During the boom however, ARMs have flourished, accounting for as much as 20% of the sizable loans volumes being underwritten in 2005 and 2006.[xiii] The unconventional structures of ARMs prove vastly more sensitive to a slowing market and the interest rate hikes that are gradually imposed by the FRB.
5. Subprime securities crisis (2007-ongoing): By the end of the first quarter, twenty five specialized ‘subprime mortgage lenders’ have gone into bankruptcy, announced losses, or are putting themselves up for sale because they are unable to raise sufficient cash flow from rapidly defaulting borrowers to pay their securities holders. Regulators and the public discover that the high-risk loans issued during the buying frenzy had been packaged into bonds in the form of residential mortgage backed securities (RMBS) and pushed through to the secondary markets. During the boom, money poured into RMBS doubling their amount to a record $476 billion. As “a segment of the market that was once Wall Street’s darling”[xiv] falls into the proverbial doghouse, Standard & Poor’s begins massively downgrading the credit ratings on mortgage backed debt securities, an official red flag of their deteriorating quality.[xv] Wall Street and the lending industry tightened their belts and clamped down on the underwriting of all loans classes that have fallen out of favour with investors.
The press announces that the flight to quality “will be most severely felt by minority and poor home buyers and owners, who will face trouble refinancing adjustable rate loans that they can no longer afford”[xvi]. The U.S. Senate Committee on Banking, Housing and Urban Affairs begins hearings titled ‘Mortgage Market Turmoil: Causes and Consequences’ (March 22, 07), and consumer advocacy groups call for a moratorium on foreclosure as well as for an infusion of federal bail out funds to support payment-stressed families. In total “[n]early 2 million ARMs are resetting to higher rates this year and next”[xvii] throwing as many households into what has elegantly been termed ‘payment shock’. The NAR forecasts that in 2007, the U.S. will see its first drop in the median sale price since the Great Depression (April 12th, 07).[xviii] In an attempt to stem the threat of foreclosures, treasury Secretary Henry Paulson unveils a plan that involves no federal monies, but would freeze rates for five years on some categories of exotic mortgages originated between Jan. 1, 2005, and July 31, 2007.
5. Global credit crunch (mid 2007-ongoing): Bear Stearns discloses that the two subprime hedge funds have imploded amid the rapid decline in the market for subprime mortgages (July 16, 07). BNP Paribas freezes three funds (Aug 9, 07). WJS reports that the slowdown in mortgages lending had extended to other forms of U.S. consumer credit.[xix] A general drought in the credit markets brings an end to 46 leveraged financed buyouts.[xx] And as the Dow tumbles 387 points, the European Central Bank pumps $130 billion into the financial system, the U.S. Federal Reserve $24 billion[xxi]. In the midst of this, CDOs – structured packages of securities backed by bonds, mortgages and other loans more complex that RMBS, which have reached $503 billion, a fivefold increase in three years – hit the mainstream press. In general, it’s not clear just where the bottom tranches, th ‘toxic waste’ of these investments are, but at least some are have worked their way into retirement and pension funds.[xxii] The corporate ‘victims’ of the crisis start piling up: Stan O’Neal CEO of Merrill Lynch retires (Oct 28, 07); Prince steps down as head of Citigroup (Nov. 5, 07); James Cayne of Bear Stearns resigns (Jan 7, 08). Then come the write downs: Wachovia, $ 1.7 billion (Nov, 10, 07); BofA $3 billion, (Nov 14, 07); Morgan Stanley, $9.4 billion (Dec 20, 07); Bear Sterns, 1.9 billion (Dec 20, 07); Citigroup, $18 billion (Jan 15, 08); JP Morgan Chase 1.3 billion (Jan 16, 08). It is estimated that Wall Street’s largest banks and brokers will be forced to write down as much as $130 billion and losses may reach $400 billion.[xxiii]
6. Recession (Jan 2008): Talks start to help bailout bond insurers such as Ambac Financial. The markets continue to experience high volatility and the Feds cut the federal funds rate twice, back to 3-1/4%, in a bid to stop the onset of a recession. After a weak holiday season, U.S. consumer spending slows…[xxiv] [To be continued.]
[iii] Bob Ivry. Foreclosures May Hit 1.5 Million in U.S. Housing Bust (Update 3). Bloomberg March 12, 2007
[vi] David Lereah. Why the Real Estate Boom Will Not Bust – And How You Can Profit from It, Currency Publishers. 2006
[viii] Paul Krugman. Op-Ed. NYTimes August 25, 2006
[xv] Vikas Bajaj. ‘Rate Agencies Move Towards Downgrading Some Mortgage Bonds’ NYTimes July 11, 2007; Bloomberg News, July 13, 2007
[xxiii]v John Glover. ‘Subprime Losses May Reach $ Billion, Analysts Say’ Bloomberg Nov 12, 1007
[xxiv] Michael Barbaro and Louis Uchitelle. ‘Americans Cut Back Sharply on Spending’ NYTimes Jan 14, 2008; Shobhana Chandra and Andy Burt ‘U.S. Recession is Now and Even Bet as Spending Slows’ Bloomberg Feb 8, 2008