Black or White Swan?
‘Subprime mortgages do not pose a huge danger to the economy, and it’s unlikely that this factor will trigger anything of a massive nature in the general economy.’
Warren Buffett, 2007
‘The US housing market [is] showing clear signs of stability.’
US Deputy Treasury Secretary, Robert J. Kimmitt, at the World Economic Forum, Davos, Switzerland, January 2007
A summary of the views of all the key participants at this forum went on to say:
‘The global economic outlook for 2007 is full of hope. Things are generally expected to go ‘fantastically well’.’
‘The world economy is in good condition.’
The German Chancellor, Angela Merkel, at the June 2007 annual G8 meeting
The world economy, especially that of the US, did not seem to be in quite as good a shape as it looked. What goes up, comes down: all to do with that damned land price – again. We’ve been here before.
The process remains just as Homer Hoyt described it all those years ago: ‘A tight money market that limits new construction also curtails the demand for land and tends to lower its price.’ As is always the case, those in charge do not study history. Nor do they have any idea how the economy actually works.
The New ‘New Era’
By 2004, it has become accepted wisdom that the US economy is functioning better than in the past: the economic expansions are lasting longer, the recessions are much shorter; there is no inflation to speak of and, with the new ways of spreading risk that the banks have found (securitising their loans), the odds of a serious financial crisis or economic downturn seem remote. One of the Fed’s governors, Ben Bernanke, even gives a name to the new-found confidence: ‘the great moderation’.
Greatly improved monetary policy, economic ‘structural’ changes and perhaps a small bit of old-fashioned good luck have been responsible for it, he argues forcefully.
The Bankers take Bernanke’s confidence to heart, congratulating themselves once again on their successful efforts to achieve economic stability. This time things really are different, they say; the nature of banking has changed fundamentally and forever. Thanks to securitisation and derivatives, banks are no longer taking the excessive risks they once used to: banks are now ‘spreading’ the risk, not storing it.
There is no shortage of money to play with either. Between February 1996 and October 1999, the money supply increases by approximately $1.6 trillion, almost 20 per cent of GDP. At this rate, the supply will double in just the next eight years.
Before long we will not be able to work out what is happening with the money supply, however. By 2006 the Fed is going to deem the measure unimportant and stop calculating it.
New banks are starting up everywhere, but in particular around developing suburbs in areas like Southwest Florida, Atlanta and parts of California. To cater for the increased demand for mortgages, 630 new banks are established between 2003 and 2007, raising $8.9bn in capital.
Throughout 2005 the strong housing market creates a large number of vacancies at lending institutions. Thousands take the opportunity to change profession and become a mortgage broker.
Countrywide financial CEO Angelo Mozilo proclaims loudly that his company will maintain a strong focus on growing market share, with the aim of achieving a 30 per cent market share by 2008. A profusion of real estate books argue that there has never been a better time to buy property, or to start a real estate career.
None of the books makes even a passing reference to the possible existence of a real estate cycle. In 2005 hurricane Katrina, the sixth strongest Atlantic hurricane ever recorded and the third strongest to make the US coastline, slams into New Orleans.
Fears are raised for the US economy. However those who know their economic history know that, as the event is not credit-related, its effect on the economy will not be long-lasting – the Chicago 1871 fire and the 1907 San Francisco earthquake taught us this. For everyone else, the juggernaut US economy takes on the appearance of invincibility, immune to anything nature can throw at it.
In 2006 US stock markets reach all-time highs, continuing the repetition of past cycles. President George W. Bush continues with his tax cutting initiatives and tries to make them permanent. We know the effect this will have on land price – an effect policymakers are simply unaware of.
Into the Peak
US homeowners are not the only persons demanding mortgages. The CEOs of the Wall Street investment banks are increasing their companies’ trading risks, diversifying into hedge funds and the world of leveraged buyouts, and, of course, vastly expanding all manner of lending practices
– even buying mortgage companies when they have to.
As the decade progresses, the amount of top-rated, triple A corporate debt begins to shrink. This may be due partly to corporations’ enjoying better cash flow – not having to raise additional cash via the debt markets – but it may also signal the ease with which it is now possible to sell far more risky debt to investors.
With returns on AAA-rated debt falling, many traditional buyers, the life assurance and pension funds, begin to seek new ways to lift returns, using derivatives or chasing higher risk – but higher return – debt. By mid-decade, the outlook is all roses. Business has never seen it so good.
The community begins hailing Fed chief Dr Alan Greenspan as ‘the greatest central banker that ever lived’. A consortium led by the Royal Bank of Scotland agrees to buy the Dutch bank ABN Amro. The deal has an astronomical price tag, but a heap of credit-creation possibilities. In Las Vegas the Tropicana Casino and Resort gets an overhaul.
Even by US standards this is grandiose. Scheduled for completion in 2010, the hotel will have 10,200 rooms, a convention centre, shopping mall and parking for more than 6,000 cars. ‘It’s like three mega-resorts at once,’ enthused one of the leading architects. Cisco Systems chief executive John Chambers, echoing the feelings of just about every CEO, claims repeatedly that the global economy is stronger than he has ever seen it.
The chief economist at the International Monetary Fund declares the world economic outlook to be the brightest since the 1960s, with the prospect of growth rates of more than 5 per cent continuing for years. ‘Major dislocations still appear to be a low probability event,’ he declares. The Spanish prime minister announces to the world that Spain has now joined the ‘Champions League’ of world economies and is growing ‘so robustly, and creating so many jobs, [the country will] soon be richer than Germany’.
In the UK an oft-quoted Hometrack economist exclaims: ‘there is more chance of finding Elvis on the moon than house prices crashing in the next five years’.
At the end of February 2007 world stock markets take a bit of a tumble. After almost five years of unbroken gains, market participants turn to each other and say, ‘Whoa, what was that?’ Who can explain the moods of stock markets, but it seems that HSBC Finance Corp, in one of its little-read securities filings, had highlighted some larger than normal overdue accounts in its subprime mortgage book.
This implies an increase in bad debts for the company, and a slowdown in lending. After just a few days, however, it is back to unfettered optimism among market traders. But wiser heads – those who have read their history – pause for thought.
A load of tall buildings are now on the drawing boards, or half built, with competition for the tallest really hotting up; the price of copper is reaching all-time highs – and the yield curve had just gone negative.
Even more significantly, US land prices, which went into the stratosphere as the economy approached the fourteenth year from the previous 1992 cyclical low, are now, unnoticed by the market in general, beginning to decline.
‘When land came on the market, you competed against national homebuilders who were flush with money and speculators who were jumping into the market and trying to resell it immediately,’ explained one regional builder in Alexandria, Virginia. ‘The price was high and the supply became limited.
Then the market stopped when you couldn’t get people to buy because it exceeded their ability to pay. Now we see land that’s been on the market for months.’ Past cycles have taught us that the land market is always the first to peak at the end of a cycle; it then leads the decline into ultimate recession. Nothing different is happening so far in this present cycle.
By mid 2007 a glut of homes for sale indicates a weakening housing market. Says the Wall Street Journal, ‘the market started to cool in mid 2005 after a buying frenzy that drove up the average US home price nearly 60% in the first half of the decade and more than doubled prices in many areas near the East and West coasts.’
In April, New Century Financial Corp, a mortgage lender based in Irvine, California, files for bankruptcy protection: rising interest rates are placing pressure on mortgaged home owners, prospective borrowers, and the lenders too. Most of the financial news goes unnoticed by the public, however, as the nation is transfixed on whether Paris Hilton has justly been put behind bars for her probation violation.
In late June two Bear Stearns hedge funds collapse. The funds had been holding a good deal of their assets in collateralised debt obligations (CDOs) backed by subprime mortgage loans – something that will be explained in the following pages. Worse, it appeared that a senior managing director at Bear Stearns was also managing more than $13bn worth of CDOs that had been bought by money market funds and other investors.
This was a problem because money market funds, established some years before to offer better returns than are available at a bank, and yet still offer good security for investors, are not insured by the US government since they rarely fail.
What is more, hedge funds, which take in investors’ money which they then re-invest, usually top up the total by borrowing heavily from banks to maximise their asset-buying potential. A number of banks had lent a collective $6bn to the highly leveraged Bear Stearns funds, now worth practically nothing.
The risk of further financial stress from continued exposure to subprime mortgages can no longer be ignored. Significantly, the investors in such debt begin to demand higher interest rates, on better terms, from borrowers.
On July 21 Treasury Secretary Paulson assures markets that the US is ‘about at the bottom of the housing slope’. He has to say that, but since he could not forecast the peak of the cycle it is unlikely he can forecast the low.
At the end of July 2007 the possible scale of the problem is revealed when IKB Deutsche Industriebank, a previously little-known German bank based in Dusseldorf, warns investors of probable market losses caused by its investment in the US subprime mortgage market.
This seems to have come as a shock: just ten days before IKB had reassured German markets that the bank was ‘in no respect affected’ by the recent events. The Bundesbank (the equivalent of the US Fed) plays down the threat of these mortgage problems flowing through to other German banks, but then immediately offers a rescue package to bail out IKB. The German chief regulator makes reference to the Kredit-Anstalt bank collapse of 1931 that saw Germany enter depression, so disturbed is he by what he saw at the collapsed bank.
A day later another German bank, Sachsen LB, receives a similar emergency bailout. Sachsen LB’s exposure to the US markets is a possible $80bn, via Irish funds kept off-balance-sheet. (Both banks will eventually require credit guarantees of €25bn to cover their liabilities and poor investment decisions.) Just what, exactly, was going on?
‘Subprime’ is a term used to describe borrowers with low credit scores or poor credit history, who represent a greater risk of default. Lending institutions, it seems, had been bundling all their loans and mortgages, including subprime ones, into a product that resembled a bond which other investors might be willing to buy.
The whole process – called securitisation – expands the market for loans, enabling banks to improve their balance sheets and allowing other investors access to the credit risk – and hence to supposedly increased earnings power. By 2006 there is $28 trillion in outstanding securitised loans, representing just slightly less than 40 per cent of all loans, up from a mere 18 per cent in 1990.
To keep much of their investment off-balance-sheet, banks established what became known as SIVs (structured investment vehicles), typically registered in off-shore tax havens, which happily bought into securitised debts, renamed CDOs (collateralised debt obligations), being the bundled mortgages or CLOs (collateralised loan obligations) which contain the bundled corporate loans.
It really is more simple than it looks: the financial engineering simply gathered, say, 5,000 American home loans of perhaps $200,000 each, put them together into a ‘security’ that would then be worth $1bn, that could now be bought, sold or traded by any investor, investment vehicle or other bank with the money – or ability to borrow the money – to do so.
Wall Street banks found ways to boost profits yet further by ‘slicing and dicing’ them, as the saying went, accounting-speak for merely carving the $1bn package into differently rated risk levels and hence different levels of return.
All fine when the real estate market is going up, which of course everybody under 42 believes will continue into eternity because they have never seen anything different. But the securitisation process was revealed for what it is – a structure built entirely on an escalating land price – when mortgage defaults begin to undermine the cash-flows, the earnings, and hence the structure itself. The rent is no longer affordable by productive activity.
Every 18 years; or perhaps, more correctly, every 14 years from the low of the previous cycle. Readers may rest assured that this process will continue to repeat, sure as night follows day, as long as the ground rent remains privatised and permitted to capitalise into a tradable, government-granted licence. Underpinning this behaviour is the law of rent.
The SIVs themselves are in effect borrowing short-term to then buy longer term, higher yielding debt. In the downturn some of the SIVs lose so much money that bank owners are forced to put their own capital into the fund to preserve their reputation or stave off total collapse.
Anyway, back to the unfolding drama that a collapsing land price is bringing …
On August 7TH 2007 BNP Paribas, a large French bank, comes clean on its investments in this area and freezes withdrawals on several of its managed funds (an unusual move in the investment funds industry, especially in the money markets area).
The bank says it is having trouble valuing such CDOs since many, if not most, are rarely traded on any exchange. For those in the money markets, where safety and high liquidity are absolute necessities, this statement comes as something of a revelation.
It suggests that any fund manager holding subprime mortgages as part of his portfolio may be in desperate trouble and likely to be punished by the rest of the market. Whilst BNP is freezing withdrawals, the American Home Mortgage Investment Corp files for bankruptcy. This is the second largest residential lender failure for the year so far. The company says it was pushed into bankruptcy partly by margin calls from banks that had been providing loan funds to originate the mortgages.
In mid-August KKR Financial Holdings (an affiliate of buyout specialists Kohlberg Kravis Roberts) announces huge losses as a result of ‘eroding confidence in mortgage backed securities’, and that it will no longer invest in residential real estate. The same day, First Magnus Financial Corp, one of America’s largest privately held mortgage companies, files for chapter 11 bankruptcy protection.
After closing its offices and disconnecting the phones, the company simply says, ‘In light of the collapse of the secondary mortgage market, First Magnus will not fund any future mortgage loans …’
First Magnus had not been involved in the subprime mortgage business; instead it was an originator of loans that were then bundled into the secondary loan market. More than $30bn in loans had been originated by the company and then sold on in this manner in 2006. Credit, once abundant, is suddenly becoming that much harder to get.
The same month, Goldman Sachs reports that its Global Alpha quant fund has lost 27 per cent of its value. Goldman says this is because its computers failed to predict a ‘25% standard deviation move’, an event so rare that they have only ever seen it twice before in their entire trading history. Doh! That unlooked for event – perhaps better described these days as a ‘black swan’ moment. Funny, though, how such moments – such credit blow-ups – turn up regularly, and most commonly only after land price has turned down first …
On August 22 Toll Brothers, the largest builder of luxury homes in the US, announces a fall in fiscal third-quarter profit of 85 per cent and a forced write-down of property values. Five of the largest US home builders have now reported combined losses of $1.85bn and taken charges of $2.9bn to write down land values and walk away from various property options.
Those who know Ricardo’s Law of Rent and have studied Fred Harrison’s accompanying thesis will see that this is how the land price downturn will slowly transmit itself to the wider economy.
This development is a prelude to recession. (Peaks in the building cycle follow the peak in land value, but precede the recession.) Nothing is happening differently from past cycles here either.
In an attempt to alleviate the tightening supply of credit and the rising price of risk, Federal bankers announce a series of measures, mainly to inject liquidity, i.e. cash, into the banking system. The amounts pumped in are unprecedented.
Is this the sound of helicopters starting up? The Fed’s action pacifies global stock and bond markets for the moment, but the rate of US home repossessions continues to climb. So too do interest rates: the cost of funds in the interbank money markets hits a ten-year peak as the credit squeeze begins to raise borrowing costs. (The interbank rate is significant since it is used by a number of banks and other financial institutions to fund their portfolio of assets and securities lending.)
The banks begin hoarding any available cash. Throughout the rest of the Western world, most housing markets are going the opposite way and cooling rapidly. In Spain, Astroc, a large local builder, sees its shares down 89 per cent from the high of just a few months prior, and grass begins to sprout from its many unfinished or unoccupied hotels and apartments. Lawsuits alleging share market manipulation are initiated.
Few, it seems, know anything about real estate cycles, or the effect rising interest rates have at the end of them. Spain reports that, for 2006, real estate activity accounted for slightly less than 20 per cent of its GDP.
Somewhat presciently, Bundesbank president Axel Weber states in early September that the present turmoil in markets has all the hallmarks of a classic bank run: ‘What we are seeing is basically what we see underlying all banking crises,’ he says, voicing the concerns of bankers everywhere who fear a good old fashioned bank run just like in the old days, where savers lose confidence in banks and queue to get their money out.
Despite this – perhaps because of it – the mid-September announcement by Northern Rock, a large UK bank and the fifth biggest mortgage lender in the country, that it is seeking ‘assistance’ from the Bank of England takes depositors and markets by surprise (though the share price had been weakening for months, and was well off its highs of February 2007).
Savers queue around the block at every Northern Rock branch to get their hands on their money before it’s too late. ‘I’m putting my money under the mattress,’ says one saver. To add to the public confusion, the top five UK banks had, only the month before, issued record first-half results, showing combined profits of almost £22bn. The subprime mess had just gone global.
Northern Rock was a pioneer in using mortgage-backed securities and other forms of wholesale funding to finance its UK banking expansion, rather than just tapping its depositor base. History reveals that such banks are always the first to capsize as rising interest rates into the final years of the land price cycle reveal the weakness of such a strategy (as the yield curve goes negative). History repeating. A few days later the Fed begins to cut interest rates.
An indication that few private investors have any understanding of the information presented in this book is that The Share Centre, a UK stock broker, can announce a 591% increase on the previous week’s account openings as private investors open up facilities to snap up Northern Rock shares.
At the end of a land price cycle such behaviour is financial suicide. Notably, most of the big hedge funds and professional investors continue to short the stock – so much so that the stock of shares available for this activity runs out: the first time that this has ever happened for a blue chip company in the history of the UK stock exchange.
Meanwhile, Stan O’Neal, the soon-to-be deposed boss of Merrill Lynch, spends most of the month of September working on his golf game; James Cayne, the CEO at Bear Stearns, remains at the bridge table. Neither recognises the gravity of the situation.
In October housing starts in the US drop to a twelve-year low; the sale of new homes falls to its lowest level since records began in the early 1970s; so too their prices. The Mortgage Bankers Association releases figures suggesting that more than 14 per cent of subprime borrowers are defaulting.
This, they say, is the worst foreclosure crisis since their records began in 1953. In some states, like Michigan, one in every one hundred homes is in a state of foreclosure. Higher interest rates are taking their toll, as would be expected but so few saw coming.
The extent of the developing crisis is revealed by the world’s banks as they unveil results showing possible bad debts of $30bn as a result of American homeowners defaulting on mortgages. But are they coming clean and revealing the true state of affairs? Nobody knows, though stock markets appear to be speculating that the worst may already be over for the banks and building companies: they hit new highs for the month.
Of all the so-called experts and economists, just one has been able to understand the turn in the land market (as distinct from the real estate market) and predict it before it happens – Fred Harrison. Others continue to foresee stable, or at worst subdued, conditions for 2008. This is not what the 18-year real estate clock indicates.
Market optimism proves short-lived. By November it is clear that banks will have serious work in front of them to rebuild their balance sheets and protect themselves against further losses – if they can survive the downturn.
They will have to begin ‘hoarding liquidity’. A whiff of real fear is seen in markets as it is realised the debt write-downs could approach $200bn, perhaps more. The previous year’s banking profits were indeed built on sand.
In Britain some £40 to £50bn of taxpayers’ money has been channelled to the stricken Northern Rock, to keep the bank afloat. This is almost 5 per cent of the nation’s GDP, an unprecedented figure. Central banks around the world are forced to co-ordinate their actions, and inject cash into their respective economies to the tune of $100bn in an effort to stabilise credit markets.
There is talk of the US facing its worst recession since the 1930s. But memories are short. The same thing is said in every land-price-led downturn. As further proof that few understand how the economy works, comparisons are made to credit squeezes after the dot-com bust of 2001/2, the Russian bond default of 1998 and Long Term Capital Management issues that year. Such credit crunches, however, did not come at the end of a real estate cycle, and they did not involve land value, so economic recovery was much easier.
Urgent financial news still can’t make it beyond the neglected financial pages; space elsewhere is gobbled up by rumours that the sister of Britney Spears may be pregnant. In 2008 UK house prices begin to copy their US counterparts, just as the world’s largest cruise ship, the Independence of the Seas, enters service and sails into Southampton.
An even bigger ship is expected in 2009. In an effort to stem the developing crisis, the British prime minister announces measures to ensure greater transparency in the banking system, better oversight of the regulatory bodies and a review of credit-rating agencies. (Didn’t we hear that last cycle, and the cycle before that, and the cycle before that?)
Back in the US, President Bush announces an economic stimulus package to ‘reward’ each American household with an extra $1,600. Francis Everett Townsend would be pleased. By February it seems that the selling price of some homes will fall below the value of the outstanding mortgage. This is not how it was meant to be. Don’t house prices always go up?
The online company Zillow reports on February 12 that some 30 per cent of US homeowners who bought in the previous two years now owe more on their mortgage than the house is worth. Moody’s Economy.com puts the figure at 8.8 million homeowners, or one-tenth of the entire US homeowner market. It is at such a point that prices can go into a dangerous downward spiral.
Borrowers go into foreclosure, forcing the sale of properties at discounted prices, while buyers wait for even lower prices. Nothing so quickly stops an upturn as the belief that a commodity can be bought next month or next year at the same or a lower price. In an effort to stabilise house prices, the Fed chairman asks banks to consider forgiving part of the loan for borrowers in distress.
True to form, the end of the real estate cycle hits first, and hardest, those with a high level of debt, those in the economy most dependent on the free flow of credit. Amongst them are the buyers of houses over the previous two years, and home builders, as the flow of cash dries up from lack of sales.
Such is the ‘winner’s curse’ phase of the cycle: the very worst time to be highly leveraged is the very time it looks safest to be so. The US Conference of Mayors tells America that the number of hungry and homeless persons in US cities rose dramatically in 2007. The ghosts of Coxey’s Army, struggling to afford the high land price. Extensive welfare handouts will keep today’s ghosts compliant, and docile too.
Finally facing the gravity of the situation, economists realise that real estate values have now lost around $1 trillion. Worse, it seems possible that the insurance companies’ mortgage-related risks may actually overwhelm their capital bases.
New capital will be required to fix the problem. In a further attempt to ease the worsening crisis, the world’s central banks, again in co-ordinated action, inject a further, unprecedented, $200bn into the global economy to prevent what some are now warning will be the worst recession in decades. Stock markets bounce on news of the cash injection, but not for long.
‘The Bank never ‘goes broke’. If the Bank runs out of money it may issue as much more as may be needed by merely writing on any ordinary paper.’
– From the ‘Rules of Monopoly’, by Parker Brothers
Perhaps the bankers knew what was coming, perhaps not. Regardless, 180 days from the Northern Rock collapse, a run on the investment bank Bear Stearns brings to an end its 85-year history.
Spooked by the firm’s probable exposure to the subprime crisis and related mortgages, investors withdraw, in just a single day, more than $10bn from their accounts. The run prompts a Federal Reserve taxpayer-funded bailout, although the Fed gets to avoid the words ‘taxpayer-funded’ after J.P. Morgan Chase agrees to buy the company for $2 a share (later increased to $10) once the Fed has spent $29bn on taking over the other distressed assets. $236m for a company valued at $20bn the year before …
Bear Stearns was America’s fifth largest investment bank. The bank did not take deposits from the public, like a commercial bank, but funded its operations with borrowed money. History shows that, at the end of each land-price-induced downturn, at least one investment bank will fail – the one most leveraged at the worst possible time.
Said former US Treasury Secretary Lawrence Summers: ‘It was fortunate that a natural partner was available when Bear Stearns failed – we might not be so lucky next time.’ Shades of Arthur Burns and the 1974 Franklin National Bank fiasco.
The run on Bear Stearns comes just days after the new CEO publicly denied it faced serious problems. As usual, investors are assured that nothing is wrong right to the very end, such is the nature of banking in a rent-enclosed economy.
So the Fed assumes the risk yet again for a failed bank. Said Bear Stearns CEO Alan Schwartz: ‘Due to the stressed condition of the credit market as a whole and the unprecedented speed at which rumours and speculation travel and echo through the modern financial media environment, the rumours and speculation became a self fulfilling prophecy.’
No longer can we blame the telegraph; this time it’s the internet. ‘There was, simply put,’ continued Schwartz, ‘a run on the bank.’ A repeat of history. Shortly thereafter, the Fed lowers interest rates
from 3 per cent to 2.25 per cent, the sixth such emergency decrease since August 2007. The great moderation appears to be waning.
By April 2008 the cost to the economy of all the credit creation and lending by banks so that people can afford the price of land is becoming clearer: actual losses total $300 bn. The figure may eventually be as high as $1 trillion, according to IMF estimates. Citigroup lead the pack with
reported losses of $40.9bn, followed closely by UBS at $38bn, then Merrill Lynch with $31.7bn in write-offs.
The real estate woes are turning up in all sorts of places. Lehman Brothers says in June that it expects to report a second quarter loss of $2.8bn, or $5 a share. An equity stake in the leveraged buyout of Archstone-Smith, an apartment developer, is to blame. ‘Lehman’s problems are due almost entirely to its mortgage and real estate exposure,’ noted Barron’s.
To recover the losses and rebuild their capital, banks resort either to requesting an investment in their business by the rapidly developing Sovereign Wealth Funds, taking up loans from the Fed, or to selling non-core associated businesses and /or the now not-so-essential branches.
In a further effort to alleviate the distressed housing sector, the US Senate passes a $300bn relief bill23 (read ‘bailout’) that will allow an estimated 400,000 homeowners to avoid foreclosure by permitting refinancing of their existing subprime mortgages into fixed-rate home loans,
supported by the federal government.
After threatening to veto the legislation, the Bush administration does a U-turn when the two organisations at the very heart of the US home mortgage banking system, Fannie Mae and Freddie Mac, suffer a sharp and very sudden share price fall, despite repeated assurances by Fed officials of the financial health of both.
Fannie Mae and Freddie Mac do not actually lend money or offer mortgages; what they do is buy mortgages from banks and other financial organisations and securitise those mortgages so that investors from around the world can buy them – a process that frees up bank capital to help such banks originate even more mortgages.
It is a process deliberately created by Congress to facilitate home buying for American citizens. (A process required only because the land rent is permitted to capitalise into a freely tradable price in the first place, and a process that will assist, ultimately, in maintaining high land prices – though few have the vision to see this.)
Due to the downturn, these two organisations report combined losses of $11bn for the nine months to March 31, 2008, the fear being that any further mortgage-related losses may erode their combined capital of just $81bn, rendering them insolvent and worsening the housing slump, not to mention the prospect of an unimaginable world-wide financial melt-down.
The ebullience at the top of the cycle has now well and truly turned to fear. To control that fear, the Securities and Exchange Commission decide to restrict the ability of traders to short the shares of banks and financial companies on the US stock market. It’s ironic really.
Successive American administrations spent years chastising other governments for engaging in the sort of financial socialism that is now taking place in the US, laboured for years to undermine socialist nations around the world and denounced any scheme that limited a trader’s ability to … well … trade.
‘The US banking system is safe …’
America’s ‘free market’ is tested yet again the same weekend as the Fannie Mae and Freddie Mac problems become clear when IndyMac Bancorp fails as depositors queue at its 33 branches – all come at once to get their money out, only to find it isn’t there.
This bank specialised in loans to borrowers who did not, or could not, properly document their ability to repay a mortgage. The failure of IndyMac Bancorp is the second biggest failure of a financial institution in US history, and the largest ever regulated Savings and Loan institution failure.
The numbers just keep getting bigger. This time, though, the Office of Thrift Supervision is better
prepared and knows what to do. It quickly transfers the bank’s operations to the Federal Deposit Insurance Corporation (ensuring that deposits of $100,000 or less will automatically be repaid) by creating a successor institution, the IndyMac Federal Bank. Same old, same old … the banks most heavily exposed to real estate start collapsing as land price declines.
This time the IndyMac failure will cost the FDIC a probable $8bn. Authorities say merely that the bank had succumbed to ‘huge losses from defaulted mortgages made at the height of the housing boom’. Nothing new here then either. The FDIC begins running its bank failure readiness exercises.
Meantime, the Treasury Secretary appears on ‘Face the Nation’ assuring viewers that America’s banking system is ‘safe and sound’. Funny thing this confidence – if the system really was safe and sound, everyone would know it and there’d be no need to say it. The secretary then goes
on to list a further 90 troubled US banks, but ones with ‘manageable situations’.
No wonder depositors are voting with their feet and queuing for hours. Many banks that began business in the newly developing suburbs around America are now in trouble. Bradenton, in Southwest Florida, serving Tampa and the surrounding area of about 687,000 residents, ‘was a centre of real estate speculation.
Three new banks, formed … since 2000 saw the activity as an opportunity for fast growth. Home prices surged 35% in 2005, and bankers eagerly made loans to finance houses, strip malls and condominiums. When the housing market stalled, defaults ballooned.’
Just like First Priority Bank, a bank which opened in 2003 and that has currently reported non-performing loans at 16 per cent of total assets, loans made against real estate being the problem.
The San Francisco Business Times reports that the FDIC is alarmed by bank reporting on internet blogs. ‘They’d rather keep the banking system’s troubles out of the news.’ The UK authorities go a step further and actually prohibit such reporting, making the information a state secret.
Policymakers begin to redress the now obvious deficiencies in the way banks lend to those who can least afford it. Tougher regulations are proposed. Even the Fed has second thoughts about its way of dealing with asset price bubbles. Perhaps, after all, they should be stopped before they begin?
We can be sure that, in the short term at least, new laws will not ease the downturn. In the next upturn new ways will be found by the banks to circumvent any proposed regulations anyway.
Write-downs and write-offs for the world’s banks and securities firms now stand at $468bn. It is certain that the numbers will rise and economic conditions will worsen before they get better. So much for the credit crisis. The real economic downturn should now be prepared for. As always,
it will be land-price led.
History reveals that land-price led recessions take time to recover from – at least four years, maybe more. The downturns usually lead to increased US overseas military escapades to divert attention from mounting problems at home.
The Scams, the Cons and the Corruption
It remains only for the scams and cons to come to light. When the cost of money places undue pressure on corporations to continue maximising their performance, and as land price softens with rising interest rates, poorly or fraudulently managed banks and other financial concerns will
come under pressure.
So it was with Countrywide, the banking wunderkind of the early 2000s, that by 2006 had become the largest mortgage lender in the US and, ultimately, the symbol of all the excesses that led to
the subprime mortgage crisis in the first place.
Countrywide offered loans to high-risk borrowers. It financed itself in the classic way of borrowing short to lend long. Crucially, unlike many of its competitors, the company was not diversified: it focused purely on the mortgage business. When the economy boomed, house prices went
up and lending standards came down; so, too, the regulatory oversight.
As late as September 2007, Countrywide co-founder and CEO Angelo Mozilo was heard to say: ‘We have plenty of liquidity. We’re in very good shape.’ Alas, not at the end of a real estate cycle. In the end the company was put up for sale and bought by Bank of America in a deal that will probably not affect the company’s borrowers and will help a no doubt very relieved FDIC. But it exemplifies the greed of the times.
The legal liabilities arising from Countrywide’s lending practices remain to be seen. It will be the banks that are saved, though, and if necessary the people ruined. One way in which the people will be ruined is through commodity prices.
The Fed knows (though it has no idea why) that in the present situation it has to do everything possible to stop the money supply from contracting. This it will attempt to do by printing dollars, injecting liquidity into the banking system, swapping bank assets for cash – anything that will enable banks to continue lending to one another and keep the mortgage markets functioning.
This will create inflation, good for farmers, bad for consumers, especially anyone living on a fixed income. It also spells a few difficult years ahead for those stuck in poverty in third world nations unable to afford soaring food costs. The US banking system cannot be permitted to fail.
For their part in the two Bear Stearns hedge fund collapses, two managers were indicted in June 2008 and arrested by the FBI. The Securities and Exchange Commission will sue the two for fraud, claiming they falsely told investors the managed funds were in good condition.
A slew of further lawsuits by investors claiming to have been misled can be expected. The real Bear Stearns scam, however, may have been on the stock market. Just days prior to the fall of the company, options exchanges granted a substantial number of requests to open March and April 2008 puts with exercise prices as low as $20, although the Bear Stearns share price was above $70 at the time. Observed one US equities strategist at the time: ‘That’s incredibly aggressive. Someone was intimately familiar with the timing.’
The first packaging of home loans sold on Wall Street was in 1977. Wall Street is creative when it comes to designing games for people to play. The packaging of home loans was merely another such game, which came back to haunt the economy exactly thirty years later.
The securitisation process was taken to the level of an art form in 2004 when a small group of investment bankers began meeting to design a better product for the mortgage and investment markets, to provide increased transparency and liquidity – more products to trade, more fees for Wall Street, in otherwords.
Derivatives contracts for trading, backed by loans for commercial buildings, or the CDOs highlighted earlier, were the result: securities backed by all sorts of debt. It is the same every real estate cycle: the higher the land price goes, the more debt that will be created.
History has repeated. At the end of another 18-year real estate cycle we are witness to yet another Federal-Reserve-engineered banking bailout, because of declining land prices, that will again cost the taxpayer hundreds of billions of dollars, reward risky lending behaviour and guarantee
another boom, then bust. The blame game has already started: ‘a result of too little regulation’, lamented one Congressman.
Nobel Prize-winning economist Joseph Stiglitz suggested that the Iraq war was a ‘central cause’ of the subprime banking crisis (this particular economist should know better). The former IMF chief economist thinks the problem is ‘the vast bonuses bankers receive when they lend and borrow’.
Blame anything except the government-granted licence that is land value, permitted to capitalise in price and then be used as collateral in the credit-creation process. That is the real cause. We have indeed been here before…