Thursday, January 7, 2010

Themes For 2010 - 2 - Credit Markets

The Great Credit Crisis of June '08-March '09 was triggered two years earlier by debt ratios that had exceeded the economy's ability to service them. Quite naturally, this was first felt in areas of the credit markets that were serviced by the weakest incomes, ie. subprime. As homebuilding activity reacted to oversupply and contracted, rising unemployment in this and related industries put these marginal borrowers into default. The ensuing foreclosures pressured home prices, putting large numbers of "homeowners" underwater on their mortgages. This led to more foreclosures and the cycle became self-perpetuating.

Stresses on the balance sheets of major banks started to become apparent in late 2007. Interest rates were slashed. The pyramid nature of credit derivatives was exposed shortly thereafter. Ultra-leveraged hedge funds blew up, forcing liquidations. Panic set in. Losses had exceeded 10% on (and off) global bank balance sheets. With leverage of 10:1 or greater this meant one thing: bankruptcy. For the entire financial system.

This is not the version of events described by policy makers and the banks themselves. They prefer to pin blame on certain people involved: typically regulators, politicians, borrowers, mortgage brokers, fund managers, irrational investors or anyone else that deflects attention from the simple mathematics of what happened. Deflecting attention is so easy, because by blaming people rather than a faceless structure, partisan politics can evoke human emotions. This is how it becomes possible to create a media hoopla over hundreds of millions in banker bonuses, while trillions in guarantees are simultaneously shoveled into the pockets of agencies like Fannie and Freddie with nary a peep. One problem evokes ideological debate, while the other (10,000 times larger) has received bipartisan support for decades.

I trust that my readers are intelligent enough to see through this charade. Once this bickering is completely ignored, the simple facts of what happened and what our present situation entails for the future become totally transparent. Our job here is not to pin blame on Democrats or Republicans for the current state of affairs or past events. Our job is to simply acknowledge that credit flows have been the primary determinant of the business cycle and of major asset markets for decades. By following some indicators of these credit flows, we should then be able to determine which part of the business cycle we are in and what that should mean for asset prices going forward.

Credit Markets

The existing debt stock in the US, inclusive of government, consumer, financial and corporate debt is estimated to be $53 Trillion. This excludes unfunded liabilities and credit derivatives. Total US GDP was $14.2 Trillion in 2008. This gives total debt 370% greater than GDP, illustrated below.

A larger portion of our incomes are required to finance this debt as the ratio increases. This has been ameliorated by falling interest rates. As rates have fallen and debt has accumulated, the overall servicing burden on the economy has remained somewhat constant. 10-20% of our incomes go toward debt servicing. When interest rates started falling in 2007, the servicing burden eased toward the lower band of 10%. Incomes were freed to be spent or saved elsewhere. This has created a temporary resurgence in economic activity. The reason I suggest this is temporary, is because interest rates are primarily a market price for money. As economic activity accelerates and people start to believe it will continue, the cost of funds rises. Because of interest rate convexity (changes in rates have greater impact the lower they are), even a slight increase in rates will have disastrous consequences. At a current rate of 4% for all debt outstanding (derived from the Lehman Agg Bond Index), we are back to using 15% of our incomes for debt servicing. Should rates rise to 6%, we'll need 22.3%. I highly doubt an economy can grow with debt servicing ratios above 15%. It crimps our ability to invest in productive capacity and to replace old and obsolete capacity. It is like a tapeworm, sucking the life out of the patient.

There are a number of ways out of the above conundrum. Historically, when interest rates have fallen, the nominal debt level has been much lower (relative to output), resulting in a debt servicing burden far below 10%. This has encouraged huge amounts of investment, and the economy has grown into its debt burden. But our starting point is far more problematic this time around. Government spending and consumer spending without increased tax revenues or incomes respectively, do nothing but increase the overall debt burden. It is investment in productive capacity that is required. As I'll show, this is not yet happening.

The other way around the situation is for debt to be retired, ie. paid back at an increasing rate or defaulted on. This appears to be the market's preference, but the various legislative and executive actions taken since the onset of the crisis have been direct attempts to prevent this from occurring. This has had the effect of masking the market values of some credit instruments. Like morphine, this does not eliminate the disease. It only buys time for the economy to grow into its debt burden.

If loan losses had ceased and money was being poured into investment, I could see the argument being made that the recession was over. Considering the credit crisis was caused by these very problems (bad loans piling up on bank balance sheets), and with aftereffects like the falling stock market and rising unemployment being mere symptoms, logic would suggest that the disease would at least slow down before we claimed victory. But loan delinquencies in nearly every category continue to deteriorate at or near the same rate. See the Fed's delinquency report here. Notice that real estate loans, both residential and commercial are falling delinquent at an accelerating rate all the way through Q3 - almost 1% of loans per quarter. C&I, Agricultural and Lease delinquencies are rising as well. Only the consumer loan category has shown any signs of abating. It has merely stabilized at all-time highs.

The increasing stresses on residential mortgages should come as no surprise to anyone. 1/4 of all mortgages are underwater, ie. the price of the residence is worth less than the mortgage. Half of that group are 20% or more underwater. (source: First American CoreLogic).

So why aren't the banks announcing writedowns on these bad loans? First, they're not foreclosing on them. Various foreclosure moratoria have prevented banks from foreclosing. And the modification efforts have stalled hundreds of thousands more. Second, banks have been given free reign to value their assets at whatever they like in the accounting process. But the losses still exist, and they will need to be taken. This is one reason why we hear of "banks not lending money." Their balance sheets are so impaired that they can't.

The above is a chart of Allowances for Loan and Lease Losses (ALLL). With the enormous inventory of delinquent loans, this metric should be rising in anticipation of the writedowns. But making provisions is not free. Capital needs to be freed from elsewhere. This crimps the banks' profits and therefore their ability to make huge bonus payouts.

Regulators and policymakers have been telling us that the banks' health is improving. This is a lie. Not only are ALLL at all-time lows in the face of all-time highs in loan delinquencies, but the too-big-to-fail banks that caused so much systemic risk in 2008 are even bigger today. If I were a cynic, I would think that they are merely keeping up appearances to justify enormous end-of-year bonuses.

One argument to the above weakness I have heard suggests that it is all rear-view thinking. The banks are being recapitalized with favourable lending spreads and their leverage ratios are falling. This is true, but in the face of what? See below.

Notice the lull in resets during 2009 as subprime mortgages became less of an issue and Option-ARM resets hadn't quite got going yet. There will be no such reprieve in 2010. A wave of recasting mortgages will hit banks this year. And with such high numbers of these borrowers significantly underwater, a large percentage will end in foreclosure. In most cases, the quality of these loans were just as bad as their subprime counterparts. Negative amortization loans, teaser rates, and various "pick-a-pay" loans are all included in this category.

A few things to note from the chart above. First, it is two years old. So the number of recasting Option-ARMs may be slightly overstated as some have been already walked away from, foreclosed, or renegotiated. However, one should also note the vintages. Option-ARM mortgages typically recast every 5 years. So the influx of such recasts in 2010 suggests that their vintage is primarily 2005 - right near the peak of the housing bubble.

Another important indicator for the overall health of the credit markets can be found in refinancing activity and new credit creation. By all accounts, these metrics are declining rapidly.

The Mortgage Bankers Association provides weekly data on purchase applications and refinance activity. (Chart courtesy Calculated Risk)

There was a brief blip in activity earlier in the year, but starting in October, mortgage applications began falling off a cliff. Indeed, there are many buyers who have simply paid cash for distressed properties and these will not show up here. But their overall impact is still fairly benign. Keep in mind that this index is moving lower despite a large tax credit for homebuyers and massive efforts to refinance existing mortgages (HAMP).

Evidence of weak credit expansion can also be found in the latest Fed Senior Loan Officer Survey. While demand for loans and willingness to lend appears to have risen appreciably since the spring, a majority of respondents still suggest that demand is weakening while lending standards continue to tighten.

Some entities, however, have had an easier time finding access to credit over the past year. Many large multinational corporations have managed to take advantage of the Fed's asset purchase/swap programs by refinancing their obligations and restructuring the duration of their debts. Real Estate Investment Trusts (REITs like SPG and KIM) are perfect examples of this. Saddled with debts owed to major investment banks, mall owners and the like were bordering on bankruptcy. But by stashing these debts on the Fed's balance sheet through the TALF program, the REITs have managed to rollover their near-term obligations while the IBs have been book-runners for numerous equity offerings, reaping major profits in the process.

Although this could be considered positive to those hoping their stocks don't become worthless (like that of GGP, for example), I see it as more malinvestment which needs to be liquidated at some later date. It kicks the can down the road. Business prospects for these companies are bleak. Even as their current status quo was rescued, their ability to service these future debts was rapidly weakening. Retail vacancies rose from 12.9% in 2008 to 18.6% in 2009. Meanwhile, asking rents have fallen 8% over the past year. This is the primary revenue generator for mall operators. When the malls were purchased during the leveraged buyout (LBO) craze of the '04-'07 years, the prospectuses for the new debt issues projected steadily appreciating rents and constant-level demand for square footage. This has now proven to be wildly optimistic, yet the Investment Banks feel it prudent to continue extending them credit at low rates.

If the above sounds like moral hazard in action, you would be correct. The Investment banks feel like they will always be able to throw their losses upon either the Fed or taxpayers. So there is no risk to them in extending high-risk credit at low-risk rates. This may buoy the stock prices of banks, but it is a net negative for the economy and the credit markets as a whole. Obviously bad loans being extended is not a recipe for recovery. It is a recipe for disaster. One would think we should know that by now.


On the whole, credit markets have not recovered. In fact, in many areas credit quality has continued to deteriorate unabated. A pending supply of low grade mortgage recasts, along with an overhanging inventory of underwater mortgages will likely force a continuing deterioration in loan performance and further house price declines. Despite accounting shenanigans that allow banks to value their assets at whatever they like, banks' lending ability remains constrained, while the ability and willingness to borrow is also under pressure. The overall amount of debt outstanding is also constraining the economy's ability to lend its way out of the recession. Even with historically low rates, the high level of debt gives us a servicing ratio that constrains our ability to invest in productive capacity.

I will detail what the implications of this are for the economy in Part 3.

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