The Oser View

Rice

One-fifth of the calories consumed by human beings come from rice. Rice is the staple diet for half the world’s population. The price of rice futures on the Chicago Board of Trade has increased 86% since last summer.

The US Department of Agriculture’s latest estimate for global milled rice production in 2008 is a record 425.3 million tons. But, projected year-end stockpiles of 77.2 million tons will be just half what they were in 2001. Rice is unusual in that only about 6.5% of the total global harvest is exported. The rest is consumed in the countries where it’s grown. For example, China, which grows 30% of the world’s rice, consumes 98% of its production. Indonesia, the third largest producer, is a net importer. The United States accounts for a mere 1.5% of global production, yet we are a major rice exporter because we consume less than two-thirds of what we grow.

Thailand is the world’s number one rice exporter by far. Though it grows less than 5% of the world’s rice, it represents a third of the export market. Export prices for Thailand’s top-grade milled white rice have risen 58% just since March and have more than doubled since late January. The year-over-year price increase is 163%. Vietnam is another major exporter, but its authoritarian government recently "asked" rice exporters to stop signing new contracts, at least until June. The government is also considering a special tax on exports. As a result, Vietnam’s exports are expected to decline 11% in 2008, and prices could rise 30% more, from $700 to $900 a ton. China, India, and Indonesia have also imposed export restrictions, and Pakistan will ship 15% less rice because of power shortages at rice mills.

The Phillipines are at the other end of the spectrum. Already the world’s largest rice importer, the country is expected to increase this year’s imports 42% to curb speculation. Phillipines President Gloria Arroyo recently warned against hoarding and threatened jail to anyone "stealing rice from the people." US ambassador Kristie Kenney promised to supply all the rice needed, not so much for humanitarian reasons, but because the Phillipines is "a front-line state in the war on terrorism."

The rapidly rising cost of rice is not an isolated incident. The United Nations Food and Agriculture Organization reported a 57% year-over-year increase in global food prices.

Commodity prices in general have been on the rise for seven years, for a variety of disparate reasons. One, perversely, is that the developing world is becoming more affluent. Ernst Engel, a 19

th

Century Prussian statistician, was the first to demonstrate that poorer households spend a greater percentage of their income on food than wealthier households. At the lowest economic strata, 80% or more of a family’s income may go for food, and poorer families subsist on the cheapest source of calories. As income increases, more meat and less starches are consumed.

Animals thus become competitors for grain with people, and since meat and dairy products are more profitable for growers, guess who wins. In the 21

st

Century, machines are becoming competitors too. Corn, wheat, soybeans, palm oil and maize are in demand as the raw material for bio-fuels. According to the World Bank, almost the entire increase in world-wide maize production between 2004 and 2007 went for bio-fuels. Rising energy prices also contribute to rising food costs by making transportation more expensive.

Another reason for rising commodity prices is speculation. Citigroup reported that investments by speculators in commodities have increased by $70 billion or 21% so far this year. Climate change is having an impact, too. Australia has been in a nearly continuous drought for seven years and during that time, its rice production has been virtually nil. In the US, heavy rains and flooding in the Mississippi delta will curtail production. More acerage in West and Sub-Saharan Africa is coming under production, but, with desertification increasing, it tends to be of poorer quality, resulting in lower yields.

Because of rising energy and food costs, inflation is building throughout the developing world. The International Monetary Fund has estimated that consumer prices in emerging economies will rise 7.4% this year, the most since 2001. In many countries, inflation will be much higher. Some places are surprising. In Latvia the inflation rate was 16.8% in March and food costs rose 21%. Next door in Lithuania, inflation rose 11.3% with food up 18.1%. The numbers for Egypt are 12.1% and 16.8%. Even in China, inflation is at an 11-year high.

Many governments are responding to rising inflation by imposing price controls. In Mexico, for instance, the government capped the price of corn tortillas at 8.5 pesos a kilogram last year. The cap is now expiring and the price of tortillas is predicted to rise to 15 pesos. The Russian government is imposing controls on bread, eggs, and milk. The World Bank reports that 21 countries, from Argentina to Yemen, now have price controls on staple foods. Price controls, however, are not free. In a globalized economy they create distortions that can easily produce more harm than good, plus they often don’t

work. Controls dampen domestic production bcause they lower farmers’ profits. In response, farmers naturally turn to growing non-controlled crops or seek ways to avoid government oversight. At the consumer level, the results are hoarding, shortages, and black markets. To prevent these consequences, the government is forced to provide deep subsidies. As the subsidies strain the government’s resources, the temptation to print money beomes irresistible, stoking the fires of inflation. When controls finally become unsustainable, an outbreak of inflation, in some cases, even hyper-inflation, is inevitable. This is just what happened in the United States in the early 1970s. President Nixon imposed a freeze on prices and wages for nearly three years to reduce the unacceptably high 4% inflation rate. By the time the controls were lifted, inflation was running at 10%.

Nothing breeds anger more than hunger. Food riots have broken out around the world in recent days, from West Africa to the Carribean, from Egypt to Indonesia. In a widely quoted remark, World Bank President Robert Zoellick, said, "The World Bank Group estimates that 33 countries around the world face potential social unrest because of the acute hike in food and energy prices. For these countries, where food comprises from half to three-quarters of consumption, there is no margin for survival."

For the past year, most of my commentaries have focused on housing and financial market issues affecting Americans. Serious as our current problems are, it can be useful to keep them in perspective. When government statisticians measure core inflation in the United States they exclude food. Changes in food prices are deemed too volatile to be useful in determining the true cost of living, and besides, Americans, on average, spend less than 15% of their income on food. What a luxury!

e ≠ mc2

Human beings’ great intellectual talent is pattern recognition.  As Harvard linguist Steven Pinker notes, we think in metaphors.  Things and actions always remind us of other things and actions, allowing us to categorize and make sense of them.  Albert Einstein’s famous equation, e = mc2, is a preeminent example of this gift.  Energy equals mass times the speed of light squared.  Einstein saw that energy and mass are fundamentally equivalent.  He recognized a pattern where everyone before him saw two entirely different phenomena.

Einsteins are few and far between.  He found a pattern where others could not.  Most of us do just the opposite.  We assume there is a pattern where none necessarily exists.  We assume that because certain relationships have held for what seems a long time on our human time scale, they will hold indefinitely.  One such relationship that has held for decades in the bond markets may be expressed, with some license, by the following equation: D = T + x, where “D” stands for the interest rate of all types of debt—personal, corporate, and government—except for direct obligations of the US Treasury.  “T” stands for the interest rate of direct obligations of the US Treasury.  “X” can be any fraction or integer greater than zero.  The interest rate of all debt except Treasuries is equivalent to the interest rate of Treasuries plus some amount, given equivalent duration for both D and T.  The key to the formula is that “x” is always positive; other debt instruments always return a higher rate of interest than Treasuries.  (It is, of course, possible to charge a lower rate than the Treasury rate on a given debt; this is a human, not a natural law.  But, such undercharging is always unusual and is called “below market rate”.)

The observable pattern was that, for any “D” and “T”, “x” would remain in a fairly consistent range over time.  For example, 30-year Fannie Mae mortgage-backed securities (MBS), which are securitized pools of 30-year single-family mortgages made to creditworthy borrowers, have about the same duration as 10-year US Treasury notes.  The difference in the interest rates between the two securities, called the yield spread, has fluctuated between 110 and 150 basis points for many years.  In other words, an investor in Fannie Mae MBS could expect to earn 1.10% to 1.50% more than an investor in Treasuries.  Recently, the yield spread between the two securities has shot up to 230 basis points and even more.

Assuming you are not a bond market professional, your reaction is probably, “So what?”  This seems a trivial change, hardly worth getting excited about.  Nothing could be further from the truth.  Spread risk—an unexpected, unprecedented, and prolonged difference in yields between types of debt instruments—occurs when market participants become conservative regarding credit risk.  Spread risk is not the problem affecting the financial markets today, but it is essential to the problem, and for our purposes, a useful guide for understanding just how dangerous present conditions are.

The current disruptions in the financial markets have been described in various ways, first as the subprime meltdown, later as a liquidity crisis, and more recently as a credit crunch. In fact, the crisis is all of the above and more.  It is nothing less than a loss of confidence in the financial system, and it is by no means limited to Wall Street.  Every governmental unit, from the federal government to the smallest local park district, every corporation, and nearly every citizen in America is dependent on debt.  The issuance of debt is fundamentally based on confidence.  No confidence, no loan.  It’s that basic.

The widening of spreads between US Treasury securities and Fannie Mae MBS is one manifestation of eroding confidence.  It’s important both symbolically and practically.  As I have often remarked in these commentaries, the 30-year fixed rate mortgage, made to a creditworthy borrower, is the bedrock of the American financial system.  In their millions, these mortgages evidence trust between creditors and debtors throughout the country.  They provide millions of jobs, both directly and indirectly.  According to Citigroup research, 776,000 jobs in construction, manufacturing, finance, and real estate have been lost since early 2006.  The Wall Street Journal estimated that New York financial companies could layoff up to 20% of their employees, and that was before the Bear Stearns collapse.  Even more crucially, mortgages allow ordinary people to accumulate wealth in the form of home equity, and they provide the borrowing power that has kept consumer spending on the rise without a break for 16 years.  The Federal Reserve reported that household net worth declined for the first time in five years in the fourth quarter of 2007, and home equity dropped below 50% of mortgage amounts for the first time since the 1940s.

Falling Treasury rates and cuts in the fed funds rate have not produced any reduction in home mortgage rates.  Thirty-year fixed-rate mortgages that conform to Fannie Mae standards carry about the same rates now that they did when the fed funds rate was 5.25%.  This is not happening because (or just because) lenders are greedy.  Mortgage rates, despite what most people think, are set less by lenders than by MBS investors.  This market is beset by rising supply and falling demand, which, as in any financial market, is a recipe for lower prices and higher rates.  Today, fewer lenders, including Fannie Mae and Freddie Mac, are able to hold mortgages on their own balance sheets, because their capital and liquidity are under stress.  According to JPMorgan Chase research, net income for all US banks in the fourth quarter fell from more than $30 billion to less than $10 billion, while loan loss provisions soared.  Loans delinquent 90 days or more rose to 1.39% of total loans.  At 1.71%, non-current real estate loans more than doubled from the fourth quarter of 2006.  Not surprisingly, regulators are demanding higher standards, tighter risk management practices and more due diligence.  At the same time, they are urging banks to raise more capital.  For many banks, the fastest way to increase capital ratios has been to decrease assets by selling them.  The assets they are selling are their most liquid, including Fannie Mae MBS.  Borrowers, meanwhile, are increasingly drawn to 30-year fixed rate mortgages, as monthly payments on 15-year mortgages become more expensive and adjustable-rate mortgages are simply unobtainable.  The combination of these factors means that more 30-year mortgages are being securitized and sold just when fewer buyers are in the market for them.

But that’s only part of the story.  The financial markets make a distinction between “real money” and “fast money.”  Real money is invested by banks and similar institutions that have the intention and capacity to hold assets for a long time.  Fast money is turned over quickly and is highly leveraged.  It is borrowed short-term and collateralized by the assets it is used to purchase.  If the market value of those assets declines, two things will happen.  Creditors will demand more collateral and they will demand a higher percentage of over-collateralization.  For example, a hedge fund might borrow $1 million and use it to purchase a Fannie Mae MBS.  In normal times, the hedge fund might have to collateralize the borrowing with $1,050,000 worth of the MBS.  Wall Street calls this a 5% haircut.  If the market value of the MBS drops from par (100) to 98, the borrower must come up with another $20,000 worth of collateral.  And when the borrowing matures, the creditor may demand a 10% haircut, meaning the debtor must pony up another $50,000.  Now the hedge fund needs $1,120,000 to borrow $1 million, but the fund is highly leveraged and doesn’t have that much capital.  If it can’t get help, it goes under. 

Of course, a real hedge fund doesn’t borrow $1 million.  Real hedge funds borrow billions.  Carlyle Capital Corp, a real hedge fund that invested in MBS, defaulted on $16.6 billion of borrowed money on March 12.  Carlyle’s creditors will sell their collateral, which puts more strain on the MBS markets and motivates lenders to demand even bigger haircuts.  Bloomberg news reported last week that banks have raised the haircuts on AAA-rated residential MBS to 20% and on non-Agency guaranteed MBS to as much as 30%.

But again, that’s only part of the story.  Credit-default swaps are defined by Bloomberg as “financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt.”  The buyer of the swap will receive the face value of the debt should the debtor fail to pay.  Note the word, “speculate.”  One might think of credit-default swaps as insurance against a company failing to make good on its obligations.  It is, but it’s a negotiable insurance policy, and so it can be traded.  On Wall Street, anything that can be traded, will be traded.  Although they have only been around for a few years, credit-default swap contracts with a total notional amount of more than $45 trillion are now outstanding.  (To put this number in perspective, it’s about 3½ times our annual gross domestic product.)  Between January 1, 2005, and June 30, 2007, the premium for credit-default swaps on Fannie Mae 10-year senior debt averaged 19 basis points.  Since then, the average has been 45 basis points, and in the last month, it has soared to 78 basis points.  Whether justified or not, higher premiums on credit-default swaps add to the cost of Fannie Mae debt by increasing the spread between Fannie Mae and Treasury obligations.

Now for the bad news.  Credit-default swaps, like interest-rate swaps, currency swaps and a host of other derivative instruments are sold between counterparties, one or both of whom is typically a large money center bank or investment bank.  Because of its incestuous nature, counter party risk is the biggest financial risk we face today.  Here is The Wall Street Journal again, describing the linkages in the financial world, “With each firm intricately intertwined with others in a maze of loans, credit lines, derivatives and swaps, the Fed and Treasury agreed that letting Bear Stearns collapse quickly was a risk not worth taking, because the consequences were simply unknowable.”  Unknowable.  Not unknown for a while until the calculations can be made, but an unknowable maze that can’t be untangled.  An analyst for Barclays Capital estimated last month that if a counterparty with $2 trillion in notional credit-default swaps were to fail, it could lead to losses of between $36 billion and $47 billion for its trading partners.  But any such failing counterparty would have many other kinds of derivative exposure and so would its partners, so that Barclay’s estimate is surely low. 

The world financial system is facing a vicious self-reinforcing cycle of less and less confidence.  The biggest loser so far is Bear Stearns.  The Fed and the Treasury, by engineering a swift bailout of the investment banking company have demonstrated that they clearly understand the seriousness of the situation.  I am reminded of an anecdote repeated by Walter Isaacson in his biography, Einstein: His Life and Universe.  Following a lecture in the early 1920s, Einstein was approached by a young physicist who claimed that the equation e = mc2 implied that huge explosive forces were latent in tiny particles.  Einstein brushed the young man off.  It wasn’t until nearly 20 years later that he came to the same conclusion and wrote the letter to Franklin Roosevelt that sparked America’s development of the atomic bomb.  Sometimes, simple equations can have very far-reaching and profound consequences.

...tails, you lose.

Oscar Wilde famously defined a cynic as someone who knows the price of everything and the value of nothing.  The wit appeals to us intuitively as we think of an old family photograph, which may have enormous sentimental value to us, but for which there is no market and therefore no price.  But let’s turn for a while to the world of financial assets, where sentimentality doesn’t, or at least shouldn’t, play a part.  When it comes to financial assets, price and value are synonymous.  The cynic in Wilde’s definition is a contradiction in terms.  If you know a financial asset’s value, you know its price, and vice versa.  Financial assets are intangible; they have no intrinsic use.  A financial asset isn’t a gallon of milk you can drink, a car you can drive, or a house you can live in.  Financial assets always and only are worth what the next person will pay for them.  The financial markets are in crisis today because the next person does not know what to pay for many of the financial assets traded in those markets.  The reason for this comes down to the difficulty, perhaps even the impossibility, of accurately assessing tail risk.

The graph above is a bell curve.  When a teacher grades on a curve, the curve in question is a bell curve.  In a class of 30 students, most scores will be in a fairly tight cluster.  Only a few, perhaps none, will score on the very high or the very low end.  Those ends are called the tails of the curve.  Over a wide number of data sets, most scores will be within 95% of the average score, and practically all scores will be within 99% of the average.   .  People who evaluate risks for a living use the same concept. Gathering relevant historical information, they calculate the probability of potential future outcomes.  Plotting the results of a school test is easy; the outcomes are finite and circumscribed. But virtually anything and everything can affect the value of a financial asset.  A risk manager may be concerned that Godzilla will rise up out of the ocean to ravage Tokyo, and, in the ensuing confusion, knock the bottom out of the market for securitized subprime mortgages.  The historical data indicate, however, that the probability of that event is less than 5%, putting it way out on the tail of the curve.  The risk manager—or more likely, the risk manager’s model—discounts it.  But suppose Godzilla does ravage Tokyo.  Now the probability is 100% and financial market participants find themselves in a predicament no one has prepared them for or warned them against.

The most recent manifestation of tail risk in the financial markets has popped up in the $300+ billion realm of auction-rate securities. Like the asset-backed commercial paper market that blew up last fall, the auction-rate securities market matches lenders who want short-term exposure with borrowers of long-term debt.  Many debtors who participate in the auction-rate markets are tax-exempt organizations or governmental units who have needs for long-term funding for capital projects, such as school or hospital buildings.  To avoid high fixed rates of interest, these entities issue bonds that are auctioned weekly at prevailing short-term interest rates. The auctioneers are the large banks or brokerages who underwrite the debt.  The sellers and buyers are money-market investors who want the safest, shortest and most liquid investments.  In the past, a shortage of buyers was rare, and when it did happen, the large bank or brokerage bought the paper, essentially acting like a market maker on the stock exchange to preserve the smooth functioning of the market.  But, the willingness of investors to buy or banks to provide a backstop was never guaranteed.
In recent days, sellers have greatly exceeded buyers in security auctions.  Sponsoring banks have been unwilling to act in the normal buyers’ stead.  When the auctions fail, the sellers must hold onto the bonds and the interest rate resets to a contractual level, which can be startling.  A few days ago, the weekly rate on a $100 million Port Authority of New York bond reset at 20% when an auction run by Goldman Sachs failed.

The Port Authority of New York is not going out of existence anytime soon, unless Godzilla transfers his attention from Tokyo to Manhattan.  Why did both buyers and banks shun the credit?  For the last 20 years or so, many municipal bonds have been insured by specialized companies who transferred their triple-A ratings to the bonds.  Since almost no municipal bonds ever default, this was a no-brainer business, the equivalent of selling life insurance to the immortal gods.  But then the insurers got greedy.  They began insuring more and more exotic types of securitized loan deals including subprime mortgage pools.  In the process, they killed the goose who laid the golden egg.  Most of these insurers are now losing their triple-A ratings, causing the municipal bonds they insured to lose theirs as well.  Many of the investors who participate in the auctions, such as tax-exempt money market mutual funds, require at least a double-A rating on the bonds they buy.  That explains the buyers’ strike.  As for the banks and brokerages, their problem is capital.  They have suffered well over $100 billion of losses tied to subprime mortgages, and they have had to retain other risky assets on their balance sheets that they would prefer to sell.  They have no wish to add significant additional assets onto an already strained capital base, even when those assets are in no actual danger of default.

The trail leads back to the tail.  The rocket scientists who calibrated the risk in subprime mortgage pools should have known that home values could not appreciate forever.  But could even the brightest of them have imagined that falling home values would create a meltdown in subprime mortgages leading to a devaluation of municipal bond insurers’ credit ratings, which in turn would cause the auction-rate securities market to seize up? Frankly, I don’t think they could have.  I think that risk was too far out on the tail to have been considered.

The crisis now playing itself out in the auction-rate securities market is a perfect example of the law of unintended consequences.  A group called the Financial Stability Forum, composed of international central bankers, recently published an interim report of recommendations or lessons learned from recent market events.  The group blames “a wave of financial innovation [that] created instruments and risk exposure so complex that risk management systems at a broad range of financial institutions, including many of the largest global banks, failed to control them effectively.”  They suggest, as a remedy, that both bankers and regulators “sharpen firms’ focus on tail risks.”

This is whistling in the wind.  The introduction of Godzilla into this commentary was not, as some readers may suppose, simply an ill-advised grasp at humor.  The point is that financial markets are at risk of anything, even pre-historic monsters, and no person or computer program can identify or guard against all of them.  The specific excesses and failures of judgment that led to the subprime mess won’t be repeated but others will be.  Different tail risks will emerge in future crises and they will be just as unpredictable as those we are seeing today.

In closing, it seems appropriate to note another tail risk in the making.  Ben Bernanke and the Federal Reserve received harsh but deserved criticism for failing to understand the magnitude of the subprime problem.  The Fed sat on its hands through the summer when it should have eased credit conditions proactively.  Now the Fed has caught up.  The dramatic reduction in the fed funds target in January to 3% leaves no doubt that the Fed gets it.  Chairman Bernanke in testimony to Congress today indicated that the Fed stands ready to reduce rates further.  “More-expensive and less-available credit seems likely to continue to be a source of restraint on economic growth,” Bernanke said. ``The outlook for the economy has worsened in recent months, and the downside risks to growth have increased.''

True, but credit is constrained not because short-term rates are too high, but because lenders are afraid to lend.  They don’t know the value of the assets they are lending against.  This is a problem that only time will solve.  Continued reductions in the federal funds target rate at this stage will have a diminishing impact on easing credit conditions.  In fact, they would be counter-productive if, as is likely, they ignite fears of rising inflation thereby driving long-term rates higher.  That would cause 30-year fixed rate mortgages to become more expensive, since they are priced off long-term bond rates.  Lower short-term rates would, however, make adjustable rate mortgages cheaper and more attractive. And that’s what opened the door to the whole subprime mess in the first place.

Mortgages & Markets

The subprime crisis is an established fact.  Nationally, delinquency rates for this segment of the mortgage market are around 20% and likely to go higher.  Subprime foreclosures are also climbing rapidly, doubling in just 18 months to nearly 7% in the third quarter of 2007.  Total realized subprime losses exceed $100 billion.  But, in 2005, when delinquency rates first began to rise, many community banks, including ShoreBank, were not especially worried.  After all, we weren’t making the kinds of loans that were getting in trouble.  To this day, ShoreBank has not made a single subprime adjustable rate mortgage, let alone ones with exotic structures like “exploding ARMs.”  (These are mortgages with very low teaser rates for the first year or two that can reset up by five percentage points or more.)  ShoreBank makes fixed rate mortgages to creditworthy borrowers whose ability to repay their debt is clearly and convincingly documented.  ShoreBank does not make loans all across the country, but only in communities where we have lent for years and whose dynamics we understand well.  ShoreBank does not base its lending decisions on credit scores, which at worst can be gamed and at best are computerized attempts to mimic the skills of experienced loan officers.  ShoreBank relies on the real-life skills of actual experienced loan officers.  Perhaps most important, ShoreBank accepts the credit risk of its loans.  We put our mortgages on the books instead of selling them instantly into the secondary market.

But if we weren’t worried in 2005, we are now.  We have come to understand that the current housing predicament is not a mortgage problem but a market problem.  Nothing exemplifies the problem as clearly as the implosion of the basic premise that created and sustained the subprime lending boom.  Some of these borrowers, of whom a large percentage were first-time homeowners, were enticed by unscrupulous mortgage brokers, others succumbed to the dream of home ownership no matter what the risk, while others simply failed to understand what they were signing.  But all believed that the value of their homes could only go up.  They believed it would be easy to refinance their mortgage or sell their home at a higher price whenever they chose.  And why not?  From January 1989, when the National Association of Realtors began compiling data, through June 2005, the average sale price of existing homes in America rose in a steady upward trajectory from $113,000 to $275,000.  Because prices had always risen in the (observable) past, people believed that prices would always rise in the future.  This belief, rather than some intrinsic quality or scarcity value in the homes themselves, created an expanding pool of buyers willing to pay rapidly rising prices.

Market value is classically defined as the amount a willing buyer will pay a willing seller, with neither being under pressure to buy or sell.  But houses are usually bought on credit, so the definition must be amended:  The market value of a house is the amount a willing buyer will pay a willing seller and a willing lender will loan.  Value is legitimized by what is commonly called an MAI appraisal.  Unfortunately, the term “MAI appraisal” is often misunderstood as something more official than it really is.  MAI stands for Member of the Appraisal Institute.  The Institute is simply a trade organization that has established criteria for those it certifies; it is in no sense a regulatory body.  A good appraiser can estimate the general condition of a property and compare it to the value of similar properties in similar communities.  Thus, appraisals trail the market; they do not set it.  During the housing boom, reputable appraisers found recent sales of comparable homes at ever higher prices, which justified—indeed forced—them to raise the values on homes they were currently appraising.

Reputable lenders, like ShoreBank, working with reputable appraisers and creditworthy borrowers made mortgages on homes whose values were established by recognized market mechanisms.  We knew what the market was telling us, which was information about sales and prices.  But the market did not provide specific information on how many mortgages in a neighborhood or on a block were exploding ARMs or had been made with no equity required of the borrower.  It did not provide information on whether the mortgage payments consumed 25% or 50% of the buyer’s gross income.  It did not provide information on whether a first-time homebuyer had ever had to buy a refrigerator or pay to fix a leak in the roof or even seen a water bill.  As long as home prices continued to appreciate, the damage was masked, the rot was invisible.

Home price appreciation had kept previous episodes of high delinquency and foreclosure contained.  Prices dipped slightly in the second half of 2001, but quickly recovered.  Rapidity was an important part of the equation.  Because homes continued to sell, the comparables on which their market prices were based could be discovered from willing sales.  But when, as now, foreclosure sales start to predominate over willing sales, the determination of appraised value becomes vicious.  When an appraiser’s comparables are three foreclosure sales, instead of three market sales, the value of all houses in a neighborhood falls precipitously.

Another difference between the present situation and previous downturns is that in the past, problems in the larger economy filtered down into housing.  As a result, the impact was more localized.  Home values fell in Tulsa and Houston when the bottom fell out of oil prices.  Housing depreciated in Silicon Valley when the dotcom bubble burst.  Today, problems in housing are bubbling up into the larger economy.  Local differences, while still significant, are more smoothed out.  Lo-doc, no-doc, no-money-down, and all sorts of irresponsible mortgages were available everywhere to anyone through electronic delivery channels.  The process, begun in the 1930s, of standardizing mortgage markets is complete, but it has had the unintended consequence of standardizing housing markets as well.  This time, when delinquency and foreclosure rates spiked up, there were few markets with large groups of renters left to come in and pick up the least expensive tier of houses.

Without this push, markets have stalled.  Homeowners who can afford their mortgages and have no need or desire to move are fine.  Homeowners who would like to move, often can’t.  But homeowners who, in the past, could solve financial difficulties by refinancing, taking out a home equity line or selling their homes, are in real trouble.  The market has turned on them.  The lead story in the January 13 “Chicago Tribune” describes how home sales in south suburban Will County have fallen by a quarter and new construction has come to a halt.  Will County, according to the article, is one of the fastest growing areas in the country.  It added 21,350 households in 2006 alone and continues to benefit from a steady inflow of new businesses and jobs.  Yet, its housing market is collapsing.

The erosion of the Chicago market, especially on the South and West Sides where ShoreBank primarily operates, is considerably worse.  We can now clearly see how the damage was done.  The following chart shows how lending worked in the South Shore neighborhood of Chicago in 2005, the latest year for which this data  is available: 

Lender                        Total Loans                   Percentage Higher Cost Loans
Long Beach Mtg.                144                           96.5%
Countrywide                      137                           48.1%
Argent Mtg.                       126                           86.4%
Fremont                            124                           91.1%
ShoreBank                         100                            0.0%

These five lenders accounted for 30% of the loans made against single-family properties.  Three of them—Long Beach, Argent, and Fremont—are (or were) subprime specialists.  Nine out of ten of their loans are high-cost; that is, subprime.  Countrywide’s loans were split about half and half between high-cost and conventionally priced loans, while all of ShoreBank’s were conventionally priced.  Nevertheless, there was evidence in 2005 that the advent of subprime was a positive for the neighborhood.  Loan originations in South Shore more than doubled between 2000, when the top three lenders were Bank One, Bank of America and ShoreBank, and 2005.  Foreclosures actually declined 9%, from 223 to 203. 

But, the high cost of subprime mortgages was only part of the story.  It’s probably fair to apply national statistics to the loans made in the South Shore neighborhood, which, in turn, is representative of all ShoreBank’s Chicago neighborhoods.  A very large percentage of subprime mortgages made between 2004 and 2006, up to 93% by one estimate , were exploding ARMs.  Three-quarters of these loans did not escrow for insurance and taxes.  Moreover, African-Americans were far more likely to get subprime loans: 52% in 2006 compared to 41% for Hispanics and 22% for white non-Hispanic borrowers.

The chickens are now coming home to roost.  In 2006, 331 foreclosures were started in South Shore.  In the first half of 2007, there were 215, which annualizes to twice the 2005 rate.  For Chicago as a whole, 6,339 foreclosures were started between January and June 2007, a jump of 42% from the same period in 2006. Recently, 723 properties were offered at the weekly Cook County Sheriff’s sale earlier this month.  Half were on the South and West Sides.  There were no bids. 

It’s hard, impossible really, to say exactly how far local market prices have dropped.  The chart below shows estimates from four different sources of the one-year change in home values in Chicago, Detroit, and Cleveland.  Each source uses a different methodology, a slightly different time-frame and even different geographic definitions. 

                    Loan Performance          Case Shiller         Radar Logic     OFHEO
Chicago          N/A                                -3.24%                  -7.60%         2.16%
Detroit          -3.16%                            -11.20%                 -6.80%        -6.12%
Cleveland      -8.10%                              -4.53%                 -2.20%        -1.78%

About the only conclusion that can be reasonably drawn, is that prices are falling, but by how much is far from clear.   We estimate that locally, prices have fallen at least 10-15% so far and may well have much more to fall before bottoming.  While our neighborhoods did not boom as outrageously as Las Vegas or Miami, prices did reach unsustainable levels.  The Bank tried to stand out against the trend in the early years, but the more time that passed, the more it became apparent that ShoreBank had only two choices: Make loans based on current valuations or quit the business.  ShoreBank never seriously considered the second option.  Instead we continued to make mortgages that borrowers could afford.  We continued to make credit available to local investors for properties that cash flowed as rentals if they could not be sold once rehab was complete.

In the boom times, to abandon lending in the neighborhoods would have meant that many fewer responsible mortgages were made.  Now, in the bust times, we still keep lending, because, as Michele Collins, head of Single-Family Lending says, “There is still a need for housing and for people who want to make a living in real estate.  Just like us.  We do mortgages.  We’re not going to say, ‘We don’t do loans anymore.’ We are fighting for the life of our communities.  If everyone runs away, you can just take a shovel and bury the neighborhoods.”

Spillover

This month’s commentary comes down to a hunch, merely a guess or, to use Thomas Friedman’s words in The World Is Flat, “a leap of faith.”  Getting there is a round about journey that begins with a question economists and policy makers have been mulling over for more than a year: “What will be the spillover effects of the housing crisis?”

That housing is in crisis is beyond question.  Home values have fallen 4.5% over the past year and are expected to drop at least another 7% in 2008.  Existing home sales have fallen more than 30%, from a peak of an annualized rate of 7.21 million units in September 2005 to just 4.97 million units in October.  The inventory of existing homes available for sale has stretched to 10.8 months from 3.6 months in January 2005.  The median sales price has fallen to $207,800, its lowest since March 2005.

California, as it so often does, leads the country.  Existing single-family home sales fell almost 15% between August and September and another 2.4% in October.  Year-over-year, sales decreased more than 40%.  The median home price in the state fell 9.9% in September and 6.4% in October.  Still, at $497,000, the median California home price remains well above the Fannie Mae/Freddie Mac conforming loan limit.  According to the California Association of Realtors, sales of higher-priced homes declined “as even well-qualified buyers were affected by the lack of funds available for jumbo loans.”

New home sales fared even worse than existing home sales, dropping to an annualized rate of 728,000 units in October from a high of 1,389,000 in July 2005.  Nationally, the median sales price is down 13% year over year to $217,800.  There is an 8.5 months supply, up from a low of 3.5 months in June 2003.  The National Association of Realtors expects a further drop of 13% in 2008.   Property values are projected to fall $1.3 trillion.  Not surprisingly, the homebuilding industry is already far beyond mere recession.  The S&P index of the 15 largest publicly traded homebuilders has lost 58% so far this year and 72% from its summer 2005 high.  Several major homebuilders are in or near bankruptcy, including Levitt and Sons LLC, builders of the first planned suburb in America Levittown on Long Island.

Mortgage delinquency is spiraling out of control.  The subprime delinquency rate, which was not measured separately until 1998, stands at an all-time high of 16.3%.  Delinquency is the adjustable rate sub-sector of subprime is 18.8%.  More than 15% of subprime adjustable rate mortgages are more than 90 days delinquent or already in foreclosure.   The total US delinquency rate for all mortgages excluding those in foreclosure hit 5.59% in the third quarter, the highest since the second quarter of 1986.  The following chart puts these statistics in perspective:

                                       Third Quarter 2007 Second Quarter 1986
Mortgage Debt Outstanding    $11.1 trillion       $1.7 trillion
Delinquency                            $620 billion         $95 billion
Delinquency Rate                    5.59%                 5.68%
GDP (as of prior year-end)      $13.2 trillion       $4.46 trillion
Mortgage debt as a % of GDP  84%                    38%
Delinquency as a % of GDP      4.70%                 2.13%

The dollars are nominal—that is, not adjusted for inflation—but the percentages show how much bigger and more central mortgages are in relation to the US economy than they were 21 years ago. A similar delinquency rate not only involves far more dollars, but a much higher percentage of Gross Domestic Product.  Perhaps more than any others, these statistics reveal the magnitude of the problem.

And yet…for all the pain and distress in housing, the economy keeps on cranking out new jobs, one and a half million the last 12 months, for a growth rate of 1.1%.  The unemployment rate, at 4.7%, remains comfortably below the post-World War II average of 5.6%.  Certainly, some occupations—manufacturing, construction, and more recently, selling and mortgaging real estate—are losing jobs.  But other sectors are doing very well.  Health care and social services, which represent about 13% of the non-governmental work force, have added nearly half a million jobs this year.  Jobs in leisure and hospitality, about 12% of the workforce, added almost 400,000 positions.  At a more granular level, there was impressive job growth in the following categories: (Numbers are in thousands):

Industry                                                    Nov 2006   Nov 2007   $ Change     % Change
Electronic Markets, Brokers & Agents            788.5       809.1          20.6             2.6%
Air Transportation                                       484.5       499.5          15.0             3.1%
Internet Publishing & Broadcasting                 36.3        45.3             9.0            24.8%
Securities, Commodities, Investments          829.2      854.4           25.2            3.05%
ISPs, Search Portals, Data Processing            384.9      398.1          13.2             3.4%
Architectural & Engineering                        1,407.2   1,454.9         47.7             3.4%
Computer Systems Design                          1,296.2   1,378.6          82.4             6.4%
Management & Technical Consulting              949.3   1,024.1         74.8             7.9%
TOTALS                                                    6,176.1   6,464.0         287.9            4.7%

These job categories represent about 5.5% of total non-government payrolls, but they accounted for nearly a quarter of total net non-government payroll growth.  Health care and leisure provided most of the rest.  Now, you may think that I am about to make the rather simplistic point. US job growth is strongest in fields requiring specialized and usually technical expertise.  Such jobs are said to have “high value added,” because each worker significantly increases the profitability of the service or goods her company produces.  As a consequence these are high paying jobs.  Since more and more of them are being created all the time, we should feel a reasonable degree of comfort that problems in housing, serious as they are, will not lead to a full scale recession.  (Highly paid workers travel often, and frequently eat in restaurants, which helps explain job increases in leisure and hospitality businesses.)  While I do think this is true, to draw the conclusion from the data presented so far, begs the question: “Why are some parts of the economy doing so well, when such a key component as housing is doing so poorly?” 

Here is where things get a little round about, so please bear with me.  On November 27, Bloomberg News published three unrelated stories that caught my interest.  The first was headlined, “JP Morgan, Deutsche Bank Keep Mum on Indian Intellectual Capital.”  It told how money center banks and big investment firms have begun outsourcing investment research to companies in India.  Some, like Fidelity, have even started captive Indian research companies.  The second story bore the headline, “Ireland’s Crystal City Shattered as Waterford Shifts East.”  This article explained that the iconic Irish maker of fine crystal, Waterford Wedgwood PLC, was outsourcing 20% of its production to Eastern Europe.  The headline of the final story read, “Dutch Fret over Irrelevance as ABN Deal Leads Sales.”  It seems that so many foreign investors are buying Dutch companies that the Dutch stock exchange is losing liquidity.  In 2007 alone, outside investors will buy 300 Dutch companies for more than $200 billion, including the marquee purchase of ABN–Amro Bank.

Three quotes, one from each story, sum things up.  You can probably tell which quote goes with which story, but, really, any of the quotes would fit with any of the stories. 

“Companies first resist outsourcing.  Many fear they’ll have to fire their own analysts.  But as they are getting pressured to do more, they keep the ones that they have, bring in Irvena [an Indian company] and they can produce so much more.”
“We can source things from the East under the Waterford franchise.  That’s not going to be an event that will change the perception of the brand.”
“This is clearly the effect of the European Union, the free movement of capital.  That’s life and I’m not feeling sad about it.”

Yes, the effects of globalization are everywhere, nothing really new here either.  But now comes the hunch.  In The World Is Flat, Thomas Friedman describes the challenges and benefits of globalization for the United States.  He notes that outsourcing, the Internet, and other manifestations of globalization get the blame for large factory layoffs.  They do not get the credit for the creation of even more and better “knowledge jobs” because these are often innovative or entirely new positions, popping up in ones and twos in many different places.  Friedman can’t prove his thesis; it takes, he says, a leap of faith.  It’s a leap I’m willing to take.  I think the low unemployment rate is telling us that thousands of new jobs are being invented all the time, some within existing corporate structures, but many by people working alone with a computer or in small collaborative groups.  And whether it’s someone who makes a living writing crowdware for Facebook, creating production-ready commercial graphics on a home computer, or selling used books through Amazon.com that person is a consumer too.  And as long as Americans keep consuming, our economy will keep expanding.   

"Who Is Alan Greenspan?"

Readers of a certain age will recognize the title of this month’s commentary as an echo of “Who is John Galt?” the famous opening sentence of Ayn Rand’s 1957 novel Atlas Shrugged.  It’s difficult today to recapture the romanticism of Rand’s paean to unbridled laissez-faire capitalism, but in the conformity-ridden, Communist-haunted 1940s and ‘50s, her ruggedly individualistic heroes, Howard Roark and John Galt, stood for a freedom of self-expression that seemed on the point of being crushed out of existence.  Roark, the architect-hero of Rand’s earlier best-seller, The Fountainhead, and Galt, an engineer, worked at the junction of creativity and commerce.  They lived out Rand’s philosophy of Objectivism, essentially that consensual capitalism, in which each person conducts transactions honestly in his or her own best interests, is the surest route to universal well-being.  Or, as Galt put it, “I am a trader. I earn what I get in trade for what I produce. I ask for nothing more or nothing less than what I earn. That is justice.”

In the early 1950s, a 26-year-old PhD candidate at New York University named Alan Greenspan became part of Rand’s circle.  He fell under her spell and in fundamental ways remains under it to this day.  He calls the position staked out in The Age of Turbulence “Libertarian Republicanism,” but that’s merely a bow to modern political labels.  Free global trade, underscored by the rule of law and as little regulation as possible—these are the tenets of Objectivism in a less romantic, 21^st Century context.

This theme runs throughout The Age of Turbulence, which is really two books in one.  The first half relates the story of Greenspan’s life, and the second takes the reader on a tour of significant world-wide economic issues.  The Age of Turbulence is an amazing work in several respects.  It is written in plain comprehensible English.  Commenting on the 2006 Congressional elections, Greenspan writes, “Armey had it exactly right.  The Republicans in Congress lost their way.  They swapped principle for power.  They ended up with neither.  They deserved to lose.”  No one reading those sentences can doubt Greenspan’s assertion that he only acquired Fedspeak as a second language out of political necessity.  It is also amazing to find a 21^st Century book on economics so devoid of equations, indeed so devoid of math of any kind.  In this Greenspan follows the course of his own favorite economist, Adam Smith, whose 1776 classic, The Wealth of Nations, contains nary a calculation.  Smith considered himself a “moral philosopher.” He based his theories on observations of how people interact in the real world, a concern that permeates The Age of Turbulence.  Greenspan’s political revelations are amazing, too, especially the admission that by far the best recent Treasury Secretaries weren’t Republicans, but Bill Clinton’s team of Bob Rubin and Lawrence Summers.  They oversaw a period of fast growth, high wages and new jobs.  Best of all, they turned the Federal budget deficit into the largest surplus (as a percentage of GDP) since 1948.

Media reviews have focused on these surprising political aspects of the book as well as Greenspan’s defense of his brief and ill-considered support of George W. Bush’s tax cuts in 2001.  Readers more interested in global economics, however, should not neglect the second half.  Here Greenspan combines his Objectivist philosophy with his unparalleled experience to provide indispensable insights on a host of the world’s economic issues.  All of the individual topics are interesting: the uncertain political future of China, the debilitating effects of populism in Latin America, the economics of energy, and the need for better science and math education in the United States. But, to my mind the most critical of the later chapters concern the factors that make a modern economy successful. The first is openness.  Greenspan make openness a synonym for freedom in a way John Galt would surely understand.  A corporation must be open to change in the form of creative destruction; that is, the continual reinvention of its products, its delivery of services, its very business model.  An industry must be open to competition both domestically and internationally. It must be fettered by as little regulation as possible in order to compete successfully.  A nation must be open to international trade, not only of goods and services, but of ideas and capital.  National borders must be open to talented individuals.  Workers of all nations must be free to pursue their ambitions.

This degree of openness or economic freedom requires the proper working of Greenspans’s second success factor, the Rule of Law. A prerequisite for the fulfillment of individual ambition is state-enforcement of property rights. No one, after all, will work hard to acquire goods or real estate if there is no redress to their confiscation by others.  But the real power of the Rule of Law is not the enforcement of law.  Greenspan points out that if more than a tiny fraction of contracts had to be adjudicated, the sheer volume would quickly overwhelm the system.  Instead, the Rule of Law must be so deeply ingrained in a culture that trust in the word of others can be taken for granted.  I certainly can testify to the centrality of trust in my business, the buying and selling of bonds.  The specifics of amount and price of all the trades I execute, involving hundreds of millions of dollars a year, are agreed to verbally before any written record is created.  These verbal agreements are ironclad and never altered.  The paperwork that follows merely memorializes the trades. Once in a great while, a confirmation differs slightly from the verbal agreement.  Invariably, this is the result of clerical error or some honest misunderstanding, and is always corrected based on the initial verbal deal.  My experience is customary across the entire world of the financial markets.

The third key factor has been the success of policy makers in maintaining macroeconomic stability. Government regulation should, of course, be anathema to a true-blue Objectivist, and Greenspan’s own argument for how he came to accept his role as Regulator-in-Chief is unconvincing.  Speaking of his appointment by Ronald Reagan as Fed Chairman, he writes, “Taking office, I was in for a pleasant surprise…What I had not known about was the [Fed] staff’s free-market orientation, which I now discovered characterized even the Division of Bank Supervision and Regulation.”  Perhaps it’s matter of point of view, but that “free-market orientation” is rather less apparent to the regulated than the regulator.  At any rate, Greenspan was clearly delighted to be appointed Fed Chairman and celebrated every re-appointment.  Whether his scruples were overcome by the gratification of his ambition or by the realization of the powerful role for good central banks play is beside the point.  A degree of central regulation is necessary for macroeconomic stability. The question is, “How much?”  Greenspan’s answer is, “As little as necessary.”

Following Adam Smith, Greenspan believes that free markets are guided by an “invisible hand.”  Imbalances in demand are automatically corrected by increases in supply and vice versa.  These imbalances are constantly in the process of being created and many imbalances exist at all times.  Financial markets are remarkably inventive in finding ways to take advantage of them. But the very activity of exploiting is also self correcting.  Specifically, fast moving hedge funds are “instrumental in eliminating abnormal market spreads and presumably much market inefficiency.”  Greenspan fervently opposes the regulation of hedge funds, because the marketplace itself regulates them through “counterparty surveillance;” that is, the oversight of the large banks and high net-worth investors who lend to them.  The power of counterparty surveillance was seen in action this summer when a number of hedge funds were forced into liquidation.

Regulation is particularly necessary in those periods of crisis when the market’s own corrective mechanisms threaten too many innocent bystanders with loss of livelihood or life savings.  As Greenspan neatly puts it, “Democracy requires trade-offs.”  On the principle that he who regulates least regulates best, Greenspan lays down three rules of thumb for regulation that provides the least interference.  The first is that any regulation required by an emergency must be carefully rethought when the crisis is past.  He cites the Sarbanes-Oxley Act as a typical overreaction, in that case to the Enron and WorldCom bankruptcies, whose cost and restrictions are counterproductive.  The second rule is that “several regulators are better than one.”  This seemingly counterintuitive idea is really a form of divide and conquer.  The overlapping jurisdictions of several regulators guarantee a degree of internecine conflict that prevents the accumulation of too much power in any one regulatory body.  The third rule is a sundown provision that “regulations outlive their usefulness and should be renewed periodically.”  The principle of creative destruction should be applied to regulation as well as companies.

Read The Age of Turbulence.  It’s not a life-changing book.  It’s not great art.  It doesn’t reveal the inmost secrets of the Federal Reserve.  What it provides is an unparalleled sweeping vision of the world’s economic landscape.  Greenspan sees the full picture and describes the broadest scope.  Above all, The Age of Turbulence puts our times in perspective.  As I said earlier, it’s an amazing book

What the Stock Market Knows

Ever since it became obvious that there would be hell to pay in the world of subprime mortgages, the big question has been, “Will the consequences be confined or widespread?”  The argument for confinement is that while potential losses on defaulting subprime mortgages will be large—anywhere from $50 billion to more than $200 billion—the number is small in relation to the $10 trillion mortgage market, let alone the broader economy.  The case for wider impact is more nuanced.  It includes the impact of defaults and foreclosures on neighborhood stability, the impact of reduced real estate taxes on municipalities, the loss of spending power from declining home equity, and falling sales at home improvement, home appliance, and similar retailers. 

This summer, the argument took an unexpected turn.  The subprime mess took a vicious swipe at various debt and derivative markets.  Liquidity dried up and remains precarious.  Major banks and brokerage houses both here and abroad are reporting huge drops in third quarter income and in some notable instances, such as Merrill Lynch, large losses.  To help stabilize these markets, the Federal Reserve cuts the fed funds target by 50 basis points and European central banks refrained from expected increases in their base rates.

So why has the stock market been so strong?  Is there some secret or fundamental knowledge underlying the value of corporate America that other markets are missing?  I think the answer is that the stock market has, for quite a long time, been on to a very powerful trend that is underestimated in other quarters.  Before we explore this issue further, however, we need to examine just what the stock market has been up to recently. 

The Dow Jones Industrial Average ended 2006 at 12,463.  It was range-bound in January and February before dropping 3.3% (to 12,216) on February 27.  The sell-off was attributed to the first revelations of widespread failures among subprime lenders, most notably New Century Financial and Fremont General.  But the Dow quickly shrugged off its initial concern, making up its losses by the first week in April.  From there, the average climbed steadily reaching a record 14,000 on July 17.  It collapsed to 12,645 on August 16 as the credit markets seized up.  Since then, it has again fully recovered,getting back to 14,000 on October 1.  Other major stock indices, the S&P 500 and the NASDAQ, show similar patterns.  Since the low on February 27, the three indices have returned 16.6%, 12.6% and 16% respectively. 

The stock market’s longer-term performance is even more impressive.  Over the last five years, ending September 30, the NASDAQ has returned almost 20% and both the Dow and the S&P 500, more than 15%.  The Dow has nearly doubled since its low of 7,267 in October 2002.  Both the Dow and the S&P are at all time highs; only the NASDAQ at 2,780 is still far below its dot-com peak of 5,048.

Ah yes, the dot-com bubble.  The mother of all stock market meltdowns.  Irrational exuberance gone berserk.  How can anyone suggest that stock prices contain some profound insight with the memory of that fiasco still so recent?   Stock markets are forward-looking, and in the late 1990s, the US stock market got ahead of itself.  It overestimated the capital values of emerging Internet and telecommunications companies, but it got the idea very, very right.  Business-to-consumer e-commerce was a paltry $1.8 billion in 1997.  It rose steadily to $70 billion in 2002, right through the stock market collapse and subsequent mild recession.  This year, according to Forrester Research, B2C e-commerce is $259 billion, an 18% increase from 2006.  Business to business e-commerce exceeds $1 trillion. 

In the mid-1970s, Gordon Moore, who later became Chairman of Intel, formulated what became know as Moore’s Law.  The original expression of the law was that the number of transistors an integrated circuit could hold would double every two years, equivalently boosting computer speed and power and reducing their cost.   By the 1990s, the deeper significance of Moore’s Law became evident: All aspects of information processing are expanding exponentially except price for performance, which is declining exponentially.

No end is in sight.  In June, IBM introduced a new computer called Blue Gene/P.  According to the company, Blue Gene/P “operates continuously at speeds exceeding one "petaflop" -- or one-quadrillion operations per second. The system is 100,000 times more powerful than a home PC and can process more operations in one second than the combined power of a stack of laptop computers nearly 1.5 miles high. The Blue Gene/P supercomputer can be configured to reach speeds in excess of three petaflops, a performance level that many thought unattainable only a few short years ago.”

A quadrillion is 10 to the 15th power, or about 1/10th as fast as a human brain, which can perform 10 to the 16th operations a second.  If that seems a big gap, consider the exponential nature of computing progress.  The top of the line IBM computer of the mid-1960s, the 7094, processed 250,000 instructions per second.  By 2000, the fastest supercomputers ran at half the speed of Blue Gene/P.  At the present rate, computer speed will exceed human brain speed in less than 10 years andd keep on going.

Meanwhile, as computing power increases, computing cost decreases.  Entrepreneur and inventor Ray Kurzweil in "The Singularity Is Near" proposes the following paradigm for information technology: At first new technologies do not work well and are extremely expensive.  Next they begin to work a bit better and are still expensive.  Third, they work very well and are cheap.  Finally, they work extremely well and are nearly free.  Obvious and familiar examples are the cell phone and the Internet, but there are many, many more.  The Consumer Price Index confirms that information costs drop virtually continuously.  Over the last three and six months, information technology costs fell 10.7% and 6.6%, while personal computer prices fell 16.8% and 12.4%, a pattern that has been in place for many years

The stock market is responding to the way these exponential trends are being played out in the high levels of corporate productivity and profitability.  These trends are a major and essential factor in the relatively smooth progress of economic expansion since the recession of the early 1990s.  It’s probable that they will prove powerful enough to avert a serious recession this year or next, despite the slump in housing.  I agree with Alan Greenspan in his testimony before the Senate Banking Committee a week after 9/11:

“[T]he American economy has become increasingly resilient to shocks.  Deregulated financial markets, far more flexible labor markets, and, more recently, the major advances in information technology have enhanced our ability to absorb disruptions and recover.”

The Meaning of the Mortgage Market Meltdown

The following is taken from a talk delivered recently by Ellen Seidman Director, Financial Services and Education Project, New America Foundation and an Executive Vice President of ShoreBank Corporation.  Her remarks are the best summary of the present state of the subprime mortgage that I have seen.

Just released Census data for 2006 tell us that there are about 75 million household who own their own home, a 67.3% homeownership rate.  The rate is 73% for non-Latino whites, 46% for African Americans, and 49% for Latinos.  About 68% of these homeowners carried a mortgage, and about 26% of those also carried a second mortgage, a home equity line, or both.

About $10.4 trillion of 1-4 family mortgage debt is outstanding.  Estimates of how much of this is sub-prime vary, but a good estimate is that about 20% is sub-prime, i.e., it carries an interest rate at least 200 basis points above comparable Freddie Mac prime loans, and another 13% is “Alt-A.”.  Most of these are adjustable rate mortgages (ARMs), and many have such additional risk factors as:

• Initial teaser rates—of which about $263 billion reset between January and August of this year, with an additional $700 billion scheduled to reset between now and the end of 2008, which is estimated to be a total of at least 2 million loans.
• Options to pay interest only, or even less than that, for some period
• No escrows
• Prepayment penalties
• No or low documentation, even for wage earners (often called “liar loans”)
• Simultaneous second loans (“piggy-back” loans) that mean there is effectively no equity in the house

Whereas in 2003, about 9% of the single family mortgage debt issued was subprime ($342 billion), by 2006 that had skyrocketed to 23% ($644 billion).  More than half that was refinance.  In fact, the Center for Responsible Lending (CRL) estimates only 11% actually went to first-time homebuyers to buy their home.

Although subprime loans are only about 20% of outstandings, by the end of 2006, 60% of new foreclosure filings were of subprime loans.  CRL estimates that 20% of all subprime loans originated in 2005 and 2006 will end with foreclosure or other involuntary home loss (e.g. deed in lieu of sale).  Even Lehman Brothers thinks the rate for the 2006 cohort will approach 30%.

Both foreclosures and their precursor, delinquencies, continue upward.  By August 2007, foreclosures were up 115% from the prior year, and 36% from the prior month.  In the second quarter of 2007, almost 15% of subprime loans (17% of subprime ARMS) were more than 60 days overdue, and over 9% more were either 90 days or more overdue, or in the process of foreclosure.  Both are way up from 2006, and the increase is much higher than for prime loans.

State and local differences are large and important.  Nationally, in August 2007 one out of 510 households was in foreclosure, but this ranges from one in 27,940 in Vermont to 1 in 165 in Nevada.  The highest foreclosure rates are in Nevada, California, Florida, Georgia, Ohio and Michigan, in that order.  These states divide into essentially two groups: those where house prices ran up spectacularly at the beginning of the decade and are now declining almost as fast (Nevada, California, Florida and Georgia) and those where the broader economy is in deep trouble (Ohio and Michigan).

To put the first group into perspective, nationally, real house prices rose 86% between the fourth quarter of 1996 and the first quarter of 2006, while real rents rose only 4%.  Since the peak, real house prices have already declined 3.4%.  The national situation is not good.  However, the situation in the boom states is worse.  For example, from June 2000 to June 2006, prices in Los Angeles went up 135%; in the year since, they have declined 5.1%.   For Miami the equivalent numbers are up 140% and down 4.8%.

The result of this kind of house price run up is that, notwithstanding strong state economies, homeowners are paying a huge share of income for housing.  In California, with a median home price of $536,000 (compared to the national median of $185,000), more than half of the homeowners pay more than 30% of their income for housing, and 22% pay more than 50%.  If those payments become unsustainable—which can happen for any number of reasons, including a mortgage reset but also such normal human events as death, divorce, disability and unemployment—the price decline makes it unlikely they will be able to get out of the situation by selling or refinancing. 

In the other group, prices didn’t increase as much, but they have nevertheless also turned negative.  And moreover, these states have high and increasing unemployment rates, increasing the likelihood that someone hit with higher payments will not be able to make them, and will also not be able to refinance or sell.  In July 2007, with the national unemployment rate at 4.6%, Michigan’s was 7.2% and Ohio’s was 5.8%.  House prices in Detroit were down an astounding 11% from the second quarter of 2006 to the second quarter of 2007 and continue to fall; one out of 87 households in Detroit is in foreclosure.  In Cleveland, house prices declined 3.6% during the same period, but appear to be stabilizing.  Nevertheless, foreclosures in Cleveland have left about 10% of the city’s single-family homes vacant.

With respect to individuals, it’s important to remember that for most low-wealth people, and most minorities, virtually all their net worth is represented by home equity.  For example, according to 2004 Survey of Consumer Finances the median net worth for the bottom quartile by wealth is $1,700; within that group, the median value of houses owned is $65,000, and median debt on it is $60,700.  For non-whites or Hispanics, the median net worth is $24,800; within that group, the median value of houses owned is $130,000 and debt on it is $63,900.  For these people, and indeed for most of the middle class, losing their house means losing everything they’ve built up, their credit standing and their hope for the future.   

The situation is exacerbated by the fact that high-cost loans have been made disproportionately in low-income and minority communities.  Just-released 2006 Home Mortgage Disclosure Act (HMDA) data show that 53.7% of home purchase loans (52.8% of refinance loans) to African Americans and 46.6% of home purchase loans (37.7% of refis) to Latinos were high cost, compared to 17.7% of purchase loans (and 25.7% of refis) for whites.  In census tracts with incomes under 50% of the area median, 46.5% of loans were higher-priced (compared with 18.3% for tracts over 120%); in tracts with over 80% minority population, incidence was 46.6%, compared with 21.7% for tracts with a minority population of less than 10%.  Other sources indicate that over 1/3 of both interest only and payment option borrowers had incomes under $70,000 and over 12% had incomes under $48,000.

It is also important to understand the effect of all this on communities.  During the 1980s and 1990s, major strides were made by cities, banks and credit unions, community development corporations, community development financial institutions, and other community based organizations around the country in stabilizing and bringing back communities that had seen substantial disinvestment in the 1960s and 1970s.  This was especially the case in the Northeast and Midwest, but other neighborhoods also benefited.  Home-ownership was a major strategy in this effort, not only for individual wealth building, but for civic engagement, crime prevention, and physical rehabilitation.  Some of those same communities are now being hard-hit by foreclosures.  These include Slavic Village in Cleveland, Back of the Yards in Chicago, and North Minneapolis.

A foreclosed house is more than a financial statistic; it generally turns into a vacant house, which in turn reverses gains in community stability, results in increased crime, costs city governments money in both increased expenses and decreased taxes, and reduces nearby property values.   The best estimate of total costs per foreclosed and vacant house to local government is about $20,000.  Dan Immergluck at Georgia Tech, one of the best researchers on this topic, has shown that a single foreclosure lowers the value of homes within one city block by .9% and by 1.4% in low and moderate income communities.  In another study, he has also demonstrated the close, positive relationship between foreclosures and increases in violent crime.

One of the implications of this is that, while I think it is totally appropriate to focus attention, and especially any outside funds, on owner-occupants, and in particular lower income owner-occupants and those who appear to have been misled, confused or only mildly excessively optimistic, the community effects are there no matter who owns the house.  In many ways, the fact that in 21% of California serious delinquencies and new foreclosures and 32% of those in Nevada are in investor-owned homes (compared to 13% in the rest of the country), makes the problem for communities in those states harder, not easier, because these are the people who will walk away quickly, from multiple properties, and create vacancies and no tax revenues. 

Turmoil

Despite the reduction in the fed fund’s target rate, the financial markets remain in considerable turmoil, which we do not expect to be resolved quickly. The current crisis was triggered by higher than normal defaults in subprime mortgages, and that alone suggests that its resolution will be lengthy. The housing and mortgage markets move slowly. Talk of a “housing bubble” was in the air for more than a year before any substantial effect on mortgage originations or home values, let alone the financial markets, was felt. The turmoil has now gone well beyond housing. The trigger, after all, is not the crisis, anymore than a stray match is a forest fire. The credit markets are in the midst of a wrenching process of re-assessing risk appetite. Broadly speaking, this crisis is about the market value of various types of financial assets, not the ultimate non-payment of mortgages. Many of the assets in question are largely unknown to the general public. They trade in specialized markets and are often opaque, even to sophisticated institutional investors. The complexity of the assets themselves and the burgeoning of derivatives based on them form the perfect breeding ground for uncertainty and fear.

The re-valuation of assets has become a crisis of liquidity. In a sense it’s a mirror image of old-fashioned liquidity crises when anxious depositors stormed bank lobbies to withdraw their funds. This summer, liquidity has been drained from the banking system not from the loss of liabilities but from an excess of assets that must be funded. These assets include loans that would normally be sold into securitized pools but must now be kept on banks’ balance sheets—or not made at all. They also include assets that leveraged funds must sell to satisfy creditors. Take for example a hedge fund that raises money from institutions and wealthy individuals. The fund then borrows substantial sums to buy even more assets. This is fine as long as the assets appreciate in value or at least retain their liquidity. The double whammy hits when a hedge fund’s assets depreciate and become illiquid. This is what happened to the Bear Stearns funds that went bankrupt in July. Their assets were all triple-or double-A rated classes of securitized mortgage pools, but the pools consisted of subprime mortgages. The Bear funds could not meet the demands of investors who wanted their money back because the market for their assets had evaporated. The ultimate repayment of the assets was not the issue. Investors who hold them to maturity will receive 100 cents on the dollar in principal and all the interest that’s due them. But timing is everything.

The next step in the re-valuation came when problems in one asset class started bleeding into others. As assets with direct subprime connections became illiquid, funds (a term I am using to cover a wide variety of investment vehicles that hold financial assets) had to sell other, higher quality assets. This was the moment when contagion struck. Too many “good” assets owned by too many desperate sellers hit the market all at once. Naturally, the price of these assets fell. Other holders of similar assets found that they were worth less relative to benchmark securities than ever before. In effect, a new risk factor in these asset classes was discovered. They are still just as creditworthy, still just as likely to be repaid as formerly, but they have become outcasts. It will take a long time to win back their former status.

That’s not all. Because “good” assets of certain types can’t be sold, new ones of the same type can’t be produced. Who wants to add to positions that are already illiquid? Since these assets are often derivatives, the chain of illiquidity runs all the way back to the base assets. Consider for example, triple-A rated classes of pooled jumbo mortgages. The underlying loans are made mostly to high income borrowers with high credit scores and large down payments. The triple-A classes are supported by subordinated classes that absorb delinquencies and defaults. These securities are bullet-proof, but nobody wants them. The mortgage brokers that used to make the loans that went into the pools now can’t get funding and some have gone out of business. Borrowers have turned to their banks, which can still make the loans but now must keep them on their books instead of securitizing them. The capacity of banks to hold loans is limited, leading to credit rationing, which further reduces the options for even high net worth borrowers. Declining mortgage availability leads to fewer homebuyers, and that leads to more erosion in home values. In this way, because the credit markets ceased to function with their usual efficiency, what started as a problem for low-income homeowners has become a problem for high-income homeowners and perhaps for the whole economy.

A further piece of the puzzle must be touched on, though it can’t be given justice in this short space. This is the ABCP problem. ABCP is the abbreviation of asset-backed commercial paper, heretofore a benign and little-known asset class. ABCP was invented by banks to provide clients with cheap funding while receiving favorable capital treatment for that funding. Like all commercial paper, ABCP is short-term, but it’s collateralized by longer-term assets and often guaranteed, to varying degrees, by large bank “sponsors.” Most ABCP is rated AAA and was considered so safe that it was a staple of money market funds. But ABCP, unlike ordinary commercial paper issued by large corporations for working capital, is not transparent. This summer, investors became concerned over ABCP whose collateral contained subprime mortgage pools or collateralized debt obligations (CDOs) that held subprime mortgages. The ABCP market suddenly shriveled and new issuance became extremely pricey. As a result banks have had to fund assets that would normally have become ABCP, creating yet further strains on liquidity. The amounts involved are not trivial. Before the crisis began, more than $1.18 trillion of ABCP was outstanding; as of yesterday the amount had fallen to $927 billion.

Conditions like these make a recession more likely. A recession is defined as two or more quarters of negative growth in gross domestic product (GDP). But there can also be “growth recessions.” These are slowdowns in the rate of growth below trend during an expansionary period. Trend GDP growth in the United States is about 3% a year. Growth is expected to be below trend for the rest of 2007 and for most, if not all, of 2008. Housing will be slow to recover, constraining liquidity for consumers. We project that interest rates will fall from current levels and remain low next year. At the short end of the yield curve—that is, from overnight to two years—the driver will be the Fed’s monetary policy. The Fed’s normal response to a slowing economy and reduced credit availability is to cut the Fed fund’s target, but the Bernanke Fed has been and will continue to be more cautious than the Greenspan Fed. Former Fed Chairman Greenspan has been widely and correctly criticized for lowering the fed funds target to 1% in June 2003 and keeping it there for a full year. At that time, the Fed was concerned that the economy was on the verge of deflation, something it had limited capacity and no experience in combating. Later revisions to the data showed that deflation was not as much of a threat as originally feared, but by then the damage had been done. Very low short-term interest rates were the catalyst for teaser ARMs and other so-called “affordability product” in subprime mortgages that sparked today’s financial crisis. The Fed will not make the same mistake twice in succession.

The Fed will be unenthusiastic, but will ultimately have to bring the fed funds target below 4% to prevent the growth recession from becoming a traditional recession. Our forecast calls for additional reductions of 25 basis points at each of the last two Federal Open Market Committee meetings of 2007. We expect further cuts totaling 50 basis points in the first part of 2008, bringing the fed funds target down to 3.75%.

Rates could go higher or lower than we project. A driver toward higher interest rates could be that rising food and commodity prices finally bleed through to core inflation. This month, crude oil broke through $80/barrel and wheat went over $9/bushel for the first time. The prices of industrial metals, particularly copper, zinc, and nickel, have tripled over the last few years. Largely this has come from increased demand from developing nations. To date, low labor costs abroad and increased productivity at home have prevented producers of finished goods from passing on rising raw material costs to consumers. But this could change quickly, and if it does, the Fed might well have to step in and raise rates in pursuance of its statutory mandate to maintain price stability.

A risk to the downside is that credit-dependent consumers will finally be forced to cut back on spending. As declining or even just stable home values become embedded, homeowners will find it more difficult to withdraw equity. Even if some modest appreciation occurs, tighter lending standards for home equity credit lines could have the same effect. Credit card debt will take up some of the slack, but ultimately consumer spending could slow or perhaps contract for a quarter or two. An outright contraction hasn’t been recorded for 16 years and would almost certainly signal a genuine recession and lower interest rates.

Playing Poole

      “The punishment has been meted out to those who have done misdeeds and made bad judgments,”' Poole told reporters in St. Louis after a speech on the market for mortgages to borrowers with sketchy or weak credit histories. “We are getting good evidence that the companies and hedge funds that are being hit are the ones who deserve it.”

The “Poole” quoted above by Bloomberg News is not a televangelist inveighing against the money changers in the Temple.  He is the President of the Federal Reserve Bank of St Louis.  Another of Mr Poole’s interesting beliefs is that the problems sparked by non-performing subprime mortgages are not spreading to the wider financial services industry. 

Try telling that to the holders of bank stocks.  Large, small and in-between bank stock indices hit 52-week lows today as did many individual names. Or try telling it to corporate bond managers who are experiencing sharply falling prices for all but the very best credits. Or try telling it to the wizards of private equity. 

Just this month, Henry Kravis, one of the first and most famous practitioners of the leverage buyout, was quoted by Bloomberg Magazine, “The private equity world is in its golden era right now.  The stars are aligned.”  Not any more.  JP Morgan Chase reported yesterday that the issuance of Collateralized Debt Obligations, into which the loans and bonds that finance buyouts are often securitized, declined from $42 billion in June to less than $4 billion this month.   To put this in context, the two biggest buyout firms—Kohlberg, Kravis & Roberts and the Blackstone Group—must raise $300 billion in the next few months to pay for acquisitions that have already been announced.  And that does not include the more than $30 billion that must be placed this week to finance two huge privatizations, Chrysler and Alliance Boots, the UK equivalent of Walgreen’s.

The markets thought the subprime mortgage problem was contained following the demise of the most egregious lenders early this year and the subsequent tightening of underwriting standards.  Then the markets thought the problem was contained when the collapse of two large Bear Stearns hedge funds did not seriously harm the firm or its lenders.  (The investors, of course, lost everything.) Today’s stock market plunge and accompanying “flight to quality” Treasury buying shows that the problem is still far from contained.  And that brings us back to the Fed.

The Fed has painted itself in a corner by holding the fed funds rate at 5.25% for the last year.  Its claim that core inflation—up just 2.2% year-over-year—remains our most pressing economic problem is becoming harder to justify every day.  Liquidity is rapidly draining out of the system, and while the elimination of excesses is necessary, the long-term harm could be substantial.  JP Morgan Chase warns that “with home prices dropping and credit tightening, most of the borrowers of the roughly $500 billion of ARMs scheduled to reset over the next 18 months will probably be unable to refinance.”  The Fed should start thinking seriously about lowering the fed funds rate.  Opinions like Mr Poole’s only make the process more difficult.