I’ll throw in another factor. The mortgage equity withdrawal issue. In addition to the people who have actually suffered, a a large number of people have borrowed to spend. They are not upside down, they will not default, or any of that. However, they will not have large increases in equity available to tap for spending. This accounted for a large percentage of GDP growth over the last five years, probably it can explain more than half. Add that to all of the other issues and it is pretty hard to imagine we get by without a slowdown.
I actually meant to address that, but never got around to it.
You see, the problem with sub-primes is really just the tip of the iceberg. About which, more in due course...
As Lance points out, over the past few years, people have been drawing a lot of equity out of homes to spend it. Now, the worry isn't that these people will be upside down in their loans, or that they will default (although some percentage certainly will). But, as credit standards tighten, and home prices drop, banks simply aren't offering seconds any more.
So, that source of money, in which people have been cashing out equity in order to spend that money on all sorts of goodies, is just going to come to an end. That source of spending money will no longer be available, which means the spending spree will stop.
And that spending spree has been pretty helpful. Remove the equity financed consumer spending for the last several years, and annualized GDP growth wouldn't have topped 1% from 2000-2006, and even 2006 would've shown annualized GDP growth of only about 1.25%.
That cashing out of equity has led to a lot of consumer spending over the last decade or so, but now, that train has left the station.
And, Lance has graphs to show the effect of Mortgage Equity Withdrawal on GDP, just so you don't have to do any of that icky math.
And, as I mentioned on the last podcast, once consumer spending dries up, all of those high equity prices are going to take a hit, because all those pretty earnings estimates simply won't materialize. this is the hideous junction of Wall Street and Main Street. GDP drops because consumer spending drops. Consumer spending drops reduce earnings, which means equity prices drop.
In addition, Lance notes that risk premiums have been awfully low. He points out that the difference in yields between BBB rated1 commercial paper and the 10-Year Treasury is down to a touch over 1.5%. That's a pretty low risk premium. Another way to think about it comes from Pimco bond superstar Bill Gross:
[H]igh yield spreads dropped to the point of Treasuries + 250 basis points or LIBOR + 200. Readers can sense the severity of the diet relative to risk by simply researching historical annual high yield default rates (5%), multiplying that by loss of principal in bankruptcy (60%), and coming up with an expected loss of 3% over the life of future loans. At LIBOR + 250 in other words, high yield lenders were giving away money!
In other words, if you are loaning high-yield money, you know that three percent of the loans are gonna go into default. That's the historical number. That means the yield between treasuries, say, and high-risk paper has to be greater than 3% for you to make a dime. So, if high-yield paper is running a yield of 2.5% over treasuries, you're gonna lose 0.5% in aggregate.
"...But we make it up in volume!"
Uh, no. You don't.
So, at least one of the following things have to happen.
Interest rates (yields, actually) for high-yield paper has to rise.
You have to stop loaning out high-yield money, or go out of business, which accomplishes the same thing in the end, really.
As it happens, both of those things are happening. Credit standards are tightening, because, if you run a Federally charted bank, you really don't want auditors from the fed dropping by and asking sharp questions about your loan standards. And, since the middle of June, the yield for non-investment grade credit has jumped by 1.5%.
But, let's go back to those sub-primes for a minute. One commenter to the previous post offered:
At the moment, we have along the lines of 44 to 45 million mortgages in the U.S.
Of those, less than 14% of them are in the subprime category. Of those, something on the order of a little over 10% are delinquent on payments, for 1/4% overall.
Of those, the majority are in the process of working payment problems and solutions through their local banks.
That works out to only around 6 tenths of a percentage point of the total mortgage market that is currently in foreclosure.
How much of a swing caused all this panic? Well, we were at around 5 tenths of one percent last year at this time, so in all, the answer is about one tenth of one percent.
That's not how you look at it though.
As I explain above, no one is making big money of the high-risk stuff, because the risk premium has been to low. So any increase in perceived risk is going to make lenders very, very edgy. The problem, really, isn't that the borrowers are a bunch of shiftless losers, but rather that the lenders are now afraid of becoming overextended, because they've already been at the risk of a shearing from the low risk premiums already. And now, they're afraid of an even more serious shearing. Observe:
Moody’s and Standard & Poor’s finally got it into gear, downgrading hundreds of subprime issues and threatening more to come. "Isolationists" would wonder what that has to do with the corporate debt market. Housing is faring badly but corporate profits are in their prime and at record levels as a percentage of GDP. Lenders to corporations should not be affected by defaults in subprime housing space, they claim. Unfortunately that does not appear to be the case.
As Tim Bond of Barclays Capital put it so well a few weeks ago, "it is the excess leverage of the lenders not the borrowers which is the source of systemic problems."
So now the lenders are thinking, "Hey, wait a minute. If S&P is downgrading all this sub-prime stuff and rescinding a whole bunch of their former ratings—with more to come—how do we know we aren't going to be royally screwed when they turn their attention to rating corporate paper again, and downgrading that?"
Look, what you do as a lender is take a look at the rating. Each rating has some historical level of default, combined with the associated loss of principal. So, when S&P tells you, hey, this paper gets a BBB rating, you're gonna look for a certain yield that gives you at least a tiny premium above the loss percentage risk. If S&P drops in a few years later, and says, hey, we're downgrading all this paper to BB or B, then you've got a problem, because what S&P or Moody's is, in effect, telling you is that your chance of default is higher—perhaps significantly higher—than you thought it was a couple of years ago. That means instead of continuing to loan money, you've got to stop, because you have to have money on hand to absorb your inevitable losses.
So, that means that money for mortgages, business expansion, and a whole host of other things just goes right out the window.
So, it's not just that some sub-primes may be troublesome. The sub-primes are just the most visible aspect of a fundamental confidence crisis in risk premiums, and credit ratings across the board.
So, at the end of the day, you're looking at significantly higher interest rates, and the attendant slowing that has on economic growth, plus the evaporation of easy credit, a significant portion of which has been what has fueled consumer spending, and hence economic growth, for the last decade.
So, even if that won't lead to some hideous recession, I think we are at least looking at a period of sub-par economic growth. I wouldn't be surprised at all to see annualized GDP hovering at, or somewhat below 1%...or worse. __________ 1 Just in case you don't know what bond ratings mean, I explain it this way in my book, Slackernomics: AAA = The best money can buy. AA = Really, really very reliable. A = Hey, their word is their bond, man. BBB = These are really good guys, they know their responsibilities. BB = Okay, so they’ve had a little trouble. We’re all human, right? B = You know, business has been a little slow lately. They’re trying. CCC = Hey, calm down! You’ll get your money. Really. CC = Look, give us a little time, all right? C = The CEO just skipped town. But don’t worry. D (Default) = Hey, look, I’m really sorry about your money, man.
If the economy slows down, the Fed may cut rates, no?
IANAE either, but I agree, and this credit crunch appears to be from the bottom up, starting with sub-prime ARM’s and as Dale said, potentially working it’s way up the chain to typically high rated corporate paper. But if the Fed cut rates, it could prevent wholesale defaults of all those ARM’s, could it potentially head off the worst of the bottom up crunch?
I think at this point, with most of the equity in housing tapped, there is little likelihood of the economy overheating even with low interest rates, so why wouldn’t the fed move this direction? It seems that a downturn is inevitable and the only benefit to raising or keeping the rates where they are would be to let some blood run in the streets (buying opportunities).
Good job Dale. I have more on this stuff coming as well. Lots of rocks to turn over.
If the economy slows down, the Fed may cut rates, no? It would also nip some of the inflationary fears in the bud, no?
Maybe to both. Actually inflation does not correlate with economic growth as closely as people believe, and if it is looking like it isn’t behaving they may not cut rates. Nor is cutting rates a solution to something that is caused by factors (though exacerbated I agree) other than the level of interest rates. Housing isn’t going to turn around because of lower rates (at least not quickly, and 75 basis points won’t do it either.) The economy became way too dependent on housing, and it will take time for labor and capital to be redeployed. Hopefully that is all this is and it will be a relative blip. However, the worst recessions are connected to credit collapses, so if this feeds on itself it could get ugly (trust me, it hasn’t yet.) I don’t think that will happen, but while analytically I have been gloomy, by nature I think optimistically. So take that for what its worth.
As for financial markets carnage, well, that is far more of an issue. No predictions, just that the risk reward ratio is and has been out of whack since at least 1998. Eventually that bites you. After this correction (not even 10%) we are now back at the point where since 1998 you would have done better in a money market fund than the S&P500. I don’t know the future, or how the markets will fare this year or next year, but low risk premiums are supposed to mean low returns. Historically that relationship has been slow to assert itself at times, but when it does it is often very fast and very furious. Also, I don’t care what you hear on CNBC or anywhere else, this market isn’t cheap, or even average. It is one of the two or three most expensive in history. There are always bad things that could happen, they only kill when you pay too much.
Which means there need to be some money taken out of the system. Hopefully won’t be mine. Who am I kidding?
Re: inflation, I think you will see it come through imports from China as they finally raise their prices to make some money - just in time for us to have a decrease in demand which sounds like a good combination as opposed to price hikes when we want to buy more.
As I said, maybe on inflation. I think what you say may make sense, especially since the Chinese manufacturers are not making much money. However, if the amount of goods and services declines that implies more money chasing fewer goods and services, which is why slowdowns often see an increase in inflation, and may be part of the reason the fed tends to raise rates too far.
As for "nowhere is cheap," not far off. In my experience or research I have never seen such broad based high pricing across asset classes and subasset classes. I see a few reasonable spots, but they are slices. In a sense it is uncharted territory, which is not necessarily bad (sometimes it is different this time) but it gives me a great deal of pause and to the extent the territory looks familiar it isn’t something I like.
Of course Wall Street is littered with the tattered reputations of those who thought they knew what the future will bring, or its timing, so caution about one’s caution is always warranted.
A very lucid and logical column. No arguments from me. The only thing I’d suggest is that you don’t develop the potential consequences of lender overexposure, beyond the end of easy mortgage credit for consumers.
Couldn’t a massive bailout of the finance sector lead to increased inflation?
Poor growth, rising inflation - welcome to the end of Jimmy Carter’s term.
If the economy slows down, the Fed may cut rates, no?
As far as I understand it, even if the Fed cuts the Federal Funds Rate, borrowing prices are still going to rise. The defaults are fueling the borrowing prices, and the defaults are based on structurally and fundamentally flawed loan packages that the borrowers could never have been able to repay unless they all found vastly better jobs, or inherited. Generalizing, but probably mostly true.
Some form of government subsidy to borrowers in trouble might stop the defaults, and at least theoretically, perhaps allow borrowing prices to fall again, but it’s more like hoping and praying those rates would fall, rather than a guarantee. Besides, that subsidy might also trigger inflation.
It takes a better economist than me to explain why some forms of large lump-sum bailouts lead to higher prices and some don’t.
”When Fred Thompson makes his long-delayed entrance into the Republican presidential race, he will not tiptoe quietly. Instead, he will try to shake up the establishment candidates of both parties by depicting a nation in peril from fiscal and security threats — and describing tough cures that he says others shrink from offering…
The approach Thompson says he’s contemplating is one that will step on many sensitive political toes.
When he says "we’re getting a free ride" fighting a necessary war in Iraq with an undersized military establishment, "wearing out our people and equipment," it sounds like a criticism of the president and the Pentagon.
When he says he would have opposed adding the prescription drug benefit to Medicare, "a $17 trillion add-on to a program that’s going bankrupt," he is fighting the bipartisan judgment of the last Congress.
When he says the FBI is perhaps incapable of morphing itself into the smart domestic security agency the country needs, he is attacking another sacred cow.”
Economic woes may provide a great opportunity for a candidate who is other than "business as usual".
Good post but you failed to mention a crucial issue: the secondary and tertiary markets in the mortgages are very heavily leveraged. It only takes a few defaults to have a particular mortgage-backed product to go into default and face margin calls which drive the fund into bankruptcy. See eg Bear Stearns.
"As for "nowhere is cheap," not far off. In my experience or research I have never seen such broad based high pricing across asset classes and subasset classes."
The S&P 500 is trading at a P/E of about 15, and decreasing every day because earnings are increasing while share prices are decreasing. That is more than half of the bubble top of 200 and cheap by any historical standard.
Whatever the cause of the market sell-off, over-valuation is not it.
This is a full scale panic, there is tons of money to be made by NOT losing your head. Like Warren Buffet who has been buying.
I don’t know if you are still monitoring this, but if so drop me a line and I’ll explain why that is not true, not even close. Unfortunately the press has treated this subject abysmally, and Wall Street always finds a way to call the market cheap. Buffet may be buying, but he doesn’t think the market is cheap, and says so. He thinks what he is buying is reasonable, not the market as a whole.