Tuesday, November 15, 2005
What could give this scenario an uglier twist is the sharp increase in funny loans to funny borrowers over the past few years. “Subprime lending” to people who would not normally be able to make the grade is running at about $500 billion a year. Much of it takes the form of variable-rate, interest-only and negative-amortisation loans. Both debtors and creditors are now more exposed to interest-rate changes.the drying up of lender liquidity at the fringes of the credit market is an early sign of instability and could portend ominously for the entire american economy. as i wrote in september:
Banks have been happy to lend to marginal debtors, safe in the knowledge that they could unload many of the loans either on one of the quasi-governmental housing agencies (Fannie Mae, Freddie Mac) or to private investors in asset-backed securities. Many of these loans end up in collateralised debt obligations (CDOs, which slice up bundles of referenced loans into tranches of different riskiness for different investors). Japanese and European investors have been especially enthusiastic buyers of this sort of paper, but there are signs of battle fatigue now: spreads have widened sharply over the past couple of weeks.
the lender, ultimately, is in control of this bubble -- the borrowers of the masses would likely immolate themselves on ever-more debt for so long as lenders grant them the rope with which to hang themselves. it is when the lender -- not the borrower, but the lender -- decides that the terms are no longer advantageous that the bubble will pop. banks will only lend for so long as there is money in lending; even as banks now function only as irresponsible pass-through fee generators, without actually having to profit from interest-rate differentials themselves, a disappearance of buyers for their mortgages (and securities backed with them) will be the consequence of unprofitability in lending long-term with funds borrowed in the short-term -- that is, when the yield curve inverts.with the yield curve continuing to flatten -- the five-year note yield is now just 24 basis points less than the 30-year bond, and the 30-day is separated from the 10-year by only 64 bp, conditions quite similar to october-november 1999 -- anticipation of the unwinding of the carry trade is already shutting some credit windows.
it is in this way that the end of the american debt bubble (and the housing bubble which is its primary component) hinges on the slope of the yield curve. a recent example of this in practice is provided by the british housing market, which responded to the bank of england rate inversion of mid-2004 by promptly flattening -- which is forcing the onset of a general consumer recession. another is in the manner in which the nasdaq bubble (also driven by money borrowed at low short-term rates and then invested willy-nilly in search of capital gain) collapsed in march 2000, only two months following the american curve inversion of that january.
UPDATE: calculated risk too is seeing signs of a top.
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