In March 2007, the Cultural Economist Ron Cooke predicted a recession. Today he notes, "we are sinking into a credit crisis of very large dimensions."
Introduction
In march of this year (2007), I published an essay entitled "Warning: Recession Ahead". You can find it on my WEB site www.tce.name under the My Blog tab. Many scoffed at the time. For most economists, there was no recession in sight.
But reasonable pundits mock no more.
My basic argument was grounded in three concerns: debt, real estate and oil. Here are two little jewels from that essay:
- "It’s a wonder the financial markets have not become unglued. The size of the high yield corporate debt market has exploded to about $1 trillion. High yield? It’s high yield because the debtors are in trouble. Corporate bond defaults, now running at less than 1 percent, could easily top 8 percent if the economy goes into recession. Debt defaults are certain to increase. Private equity firms, hedge funds, and Government Sponsored Enterprises will all need help (along with some mutual funds, pension plans, banks and brokerage firms).
Thus far, struggling debtors have been buoyed up by a liquidity glut. But we must ask ourselves: how long will that generosity last?
Only until lenders perceive it is in their selfish-best-interest to bail out." - "If my analysis is correct, one to four unit residential loan delinquency rates will exceed 4 percent for 33.3 million prime loans, and 18 percent for 10 million sub prime and government insured loans by the end of 2008 (versus 2006). Total non performing consumer loan obligations, including mortgage and consumer debt, could exceed $ 700 billion."
Sound familiar? These excerpts could be from a current issue of the Wall Street Journal. We are sinking into a credit crisis of very large dimensions. Q4 of 2007 and Q1 of 2008 could be quite messy.
Home Mortgages
In the old days (before 2005), traditional mortgages were well documented, included a confirmation of the borrower’s credit risk (ability to pay), an appraisal of the property that justified the amount of the loan, and usually were made at 70 to 90 percent of the property value at the time of origination.
In the new financial era, mortgages were offered to any borrower with a "reasonable" credit rating. These instruments included interest only loans, Adjustable Rate Mortgages (ARMs), and loans with little or no documentation. Over the last 2 or 3 years, up to 50 percent of all mortgages have been funded with loans for which there was no down payment, loans for more than the current market value of the property, interest rate only deals, and ARMs with teaser rates. The result?
These loans sucked low and middle income buyers into deals they could not afford.
As one may guess, these loans carry a higher risk of default. Worse, during the mortgage bubble of 2005 and 2006, loan originators were able to pass these debt bombs through to banks, which passed them on to investment institutions, which then turned them into securities called CDOs (Collateralized Debt Obligations). As usual, the Federal Government was so entangled in political squabbling and officious posturing there was little or no effective imposition of Federal guidelines which should have put some sanity into home mortgage lending practices.
If we examine existing default rates, it would appear that total defaults are on track to exceed my original estimates by the end of Q3 2008. Once again, economic reality trumps financial greed. Investment institutions are stuck with borrowers who are unable to bring their mortgage payments up-to-date. Given the stricter lending standards banks are now imposing on loan applications, they are unlikely to be able to refinance their property. And because home prices are falling – they are unable to sell their house to repay their debt.
The decline of housing values has increased the debt to equity ratios of all mortgages. Loans that started with a high debt to equity ratio are in danger of acquiring a net negative value. These, along with outright defaulted loan obligations, than become unmarketable. Despite balance sheet manipulation, investment institutions will eventually be forced to classify them as a Level 3 asset.
More Asset Trouble
Borrowers were encouraged to go into excessive debt. This pushed up asset prices. Refinancing only works if asset prices keep going up. When the asset bubble popped, leveraged deals went into reverse. Speculators who were counting on increasing asset values in order to borrow more money or cash out got caught in a downward spiral of unserviceable debt.
The financial risk of securitized credit card debt has been increasing as borrowers exhaust their credit. It has become more difficult, and frequently impossible, to borrow additional money against the value the consumer’s home. Consumer credit defaults, including failed auto loans, will have to become Level 3 assets.
As asset values decline, the credit quality of leveraged buyout bridge loans is deteriorating. If cash flow fails to match debt payments, these will have to be written down.
The risk of asset backed commercial paper is increasing. Some portion of this debt will become unmarketable.
Multiple leveraged buyout deals are in trouble. Highly leveraged corporate debt helped to fuel stock market speculation. Let’s face it. Junk bonds are really junk!
And finally, to these risks we must add derivative contracts, credit default swaps, and other financing misadventures.
Reckless lending practices were encouraged because the securitization of these loans allowed banks to pass the credit risk on to someone else. Loans were simply packaged into CDOs and sold to a buyer. Everyone in this chain of financial deceit made money from the generation of fee income: mortgage brokers, banks, investment banks, and credit rating agencies. Clueless buyers were all too willing to purchase these instruments based on the credit rating agency’s promise they were investment grade securities.
The chain of value has lost its transparency. Who knows the value of these exotic instruments? No wonder investors have finally panicked and become risk adverse. According to New York-based Fitch Ratings, up to 27 percent of this debt carries a high default risk. If all goes well, only 5 percent will actually become worthless.
The generous financial liquidity offered to corporations from hedge and private equity funds is declining. This, along with the asset crunch, will drive more corporations into Chapter 7 or 11 bankruptcy proceedings than we have seen since the last recession.
A Small Bit Of Relief
Starting November 15, 2007, accounting rule SFAS157 requires banks to divide their tradable assets into three "levels". This requirement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. That means we should see greater debt transparency by Q2, 2008. To quote SFAS157:
"Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. A Level 1 input will be available for many financial assets and liabilities, some of which might be exchanged in multiple active markets (for example, on different exchanges).
Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly through corroboration with observable market data (market-corroborated inputs). If the asset or liability has specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability. An adjustment to a Level 2 input that is significant to the fair value measurement in its entirety might render the measurement a Level 3 measurement, depending on the level in the fair value hierarchy within which the inputs used to determine the adjustment fall.
Level 3 inputs are unobservable inputs for the asset or liability, that is, inputs that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability (including assumptions about risk) developed based on the best information available in the circumstances. Assumptions about risk include the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique."
I think these rules mean that Level 3 assets can be valued at the owner’s discretion. Since the definition of what assets can be included in Level 2 versus Level 3 is apparently "fuzzy", it is in the banks selfish-best-interest to classify as many assets in Level 2 as is possible. Even with this discretion, don’t be surprised if a few players write down more than 25 percent of their portfolio value. But this begs a question to which few investment institutions have an answer: does the fictitious value of Level 3 assets exceed the owner’s capitalization?
And that brings us to the consumer. You and me. Who bought this paper? Pension funds? Insurance companies? How good is the paper in your 401K? Your CD? Your money market fund?
Now About Oil
The only element of this three part thesis still unfulfilled is the contention that sharply rising oil prices have usually foreshadowed a decline in GDP. But that little "gotcha" (described in my prior essay) is still laying in the economic weeds. Higher hydrocarbon prices are now reducing the bottom line of every business. Big losers include airlines, trucking companies, and the food chain (from planting through distribution).It should not surprise us to discover a price inflation driven decrease in corporate profits and a loss of consumer confidence has rolled the economy over into a recession by spring. Certainly before the end of 2008.
Ronald R. Cooke
The Cultural Economist
Author: Detensive Nation
I think people tie up money