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Wednesday, January 17, 2007


disquieting signs

with a housing bust underway and getting deeper all the time, questions regarding the remainder of the economy are burgeoning -- as are opinions regarding the answer. will the american economy engineer a soft landing? or will it succumb -- as is so much more common -- to a credit crunch, contraction and a period of recession?

one fearful sign regarding the more optimistic camp is the nature of its optimism. put most candidly, it amounts to this: the models say recession, but the mind says no.

According to [Dr. Leamer's] model, the probability of a recession in one year rose to 86 percent in January 2006 and to 100 percent in March 2006, and has been stuck at 100 percent through October 2006. According to this (imperfect) predictive probability, a recession is a virtual certainty and likely to commence in the first quarter of 2007.

My view, announced in December 2005, is that this time will be different. This time the problems in housing will stay in housing. So far, I am feeling very smug. But this keeps me up at night. In this column, first the models, and then the mind. The models say that a recession is coming soon. The mind says otherwise.

"this time will be different" -- words that have a tendency to end in all-too-familiar disaster.

it's difficult to contrive reasons why a major housing collapse should stay isolated -- it never has, and for good reason. real estate is a highly leveraged investment, and as such the banking system is intertwined with housing. indeed, as housing has gone south, reports are coming in of trouble in banking. subprime lenders -- that is, those who lent specifically to the more dangerous slices of the loan market at higher rates and often in recent years with too little diligence and too much greed, becoming a very large part of new loan generation by 2006 -- have already started to go bankrupt. and now credit quality is deteriorating in midmajor banks as foreclosures begin to spike -- including, notably, marshall and ilsley and us bancorp, midwestern banks far from either coast.

"It's finally happening," said David Hendler, an analyst at CreditSights Inc., an independent research firm, who has long warned of a weakening in credit quality.He said the pain is likely to be felt disproportionately by small- and mid-sized banks that are less diversified and over-reliant on construction and mortgage lending.

U.S. Bancorp, meanwhile, saw its net charge-offs jump about 25% to $169 million in the fourth quarter. While the levels were lower than a year ago, the company said the drop off was "principally due to" the bankruptcy law kicking in. Analysts said they were surprised by the magnitude of the increase in losses, although they pointed out that U.S. Bancorp's overall credit quality remains intact.

The Minneapolis-based bank, the sixth-largest in the U.S., is girding for more loans to sour. It predicted that charge-offs of retail loans "will continue to increase moderately during 2007" and that commercial loans losses will "continue to increase somewhat over the next several quarters."

The difficulties were especially pronounced at Marshall & Ilsley, a Milwaukee-based regional bank with a $12.5 billion market value. Net charge-offs jumped to $15 million in the fourth quarter, up 30% from the previous period. Its total nonperforming assets soared to $294 million from $234 million in the third quarter and about $150 million a year earlier. The higher losses stemmed from a variety of real-estate loans, particularly those to finance construction and land development. But a thicker slice of the company's commercial and residential mortgage loans also went bad during the quarter.

such deteriorations are often the canary in the coalmine of recession. economies in general -- and particularly managed-debt economies like ours -- rely on banks to lend in order to proffer money supply and provide the access to capital that the monads of any economy -- consumers and companies -- require to grow the whole. banks make money doing this by collecting fees and interest differentials, and so -- when times are good -- they lend as much as they can. the fee component has particularly become important since the development of the collateralized debt obligation, which allows banks to package and sell off their loans, freeing capital to make more loans. with a healthy aftermarket for higher-yielding cdo tranches in times of very low interest rates adn low volatility, banks have had no trouble making loans as fast as possible and passing on the loan (and its risks) to someone else without much care for the quality of the credit.

but now that aftermarket, growing wary of a possible housing shock, has become thinner -- and banks are being forced to retain some of their loans on their balance sheets, reducing the amount of new lending that they can do (and therefore profits) while increasing the risk to their capital (by retaining loans that may well go into default). this is what is being reported at us bancorp, m&i and wells fargo -- declining profits, increasing defaults. when banks become overextended in this fashion, they reflexively slow lending to protect capital -- and the economy contracts, forcing more foreclosures, beginning a vicious spiral of debt liquidation that we call recession.

with interest rates having been low for some time, many lenders have lent an unfathomably large amount to questionable credits -- as so often happens, out of short-run greed and a wishful belief that good times will last long enough to make a packet and get out. the sheer size of what is owed -- debt financing as a percentage of disposable income (the debt service ratio) is at record levels, as is the household debt-to-asset ratio -- is at least as important as interest rates, for even at low rates the cost of borrowing is huge for that reason. worse, faced with the prospect of declining asset prices and rising interest rates, these figures will probably get much worse before they get better. indeed, it is perfectly valid to wonder if -- with so much owed -- the united states is not on the cusp of a debt-deflation event that normalizes debt levels from extraordinarily high starting points.

in any case, even if a depression isn't lurking just offstage, it seems quite sensible to expect debt service ratios to grow, credits to deteriorate, lending and money supply to falter and recession to set in -- if and when interest rates rise. and that of course is the $64,000 question.

i recently read a very interesting paper that addressed the mechanics of low interest rates -- why they are low and have stayed low, why volatility is low -- in an effort to give insight on an eventual rise. it maintained convincingly that oil money -- cash paid by the west for oil -- has been returning to western economies directly (from the mideast and russia) and indirectly (from asian central banks) as asset purchasing power, particularly the purchasing of treasury debt and the aforementioned cdo's. as oil prices have risen -- tripling since 2003 -- the windfall has ever more aggressively been reinvested to keep rates down in spite of heated economic growth and the rising threat of inflation that has seen the federal reserve bank raise interest rates 13 consecutive times (inverting the yield curve). this amounts to literal billions flowing into western capital markets annually since 2003 -- enough to also reflate global capital markets post 2001-2, narrowing credit spreads and risk premia (i.e., boosting stock markets) because oil money tends to be riskier capital. the similarity is to the 1970s, except that whereas oil savings influx abetted wage inflation (the 'real' economy) then it abets asset inflation (the financial economy) now -- a product of our structural development from an industiral to a service economy.

on this view, the rise in global oil prices amounts to a massive wealth transfer from oil importers to oil exporters -- the asset value of oil in the ground has risen by a nominal $50bn. that wealth transfer requires a corresponding markdown on western balance sheets -- one that in the 1970s was facilitated by inflation destroying the value of western assets in real terms even as they held steady in nominal terms. in this incarnation, however, not only has the markdown not yet come -- it has been preceded by a period of interest rates suppressed by recycled petrodollar income which has encouraged a massive debt buildup that will because of the level of debt involved quite possibly require a severe debt-deflation depression to correct. even if it does not -- for, say, western monetary policy reasons -- the resultant avenue of correction will be runaway inflation. either way, a large expansion of risk premia is due -- either way, credit spreads and real interest rates will increase dramatically.

this correction is to be expected once the asset-burgeoning effects of oil revenue investment inflows recede. this can result from either a collapse in oil revenue reinvestments (oil price collapse, greater spending than saving in oil exporting economies) or in a forced delevering of petrodollars removing the amplification of purchasing power (as was engineered in 1981 by fed chairman paul volcker -- this latter may now require a broader view of inflation than the fed now takes, one which includes energy and asset prices). but the telltale indication is likely to arrive in expanding credit spreads, which have remained narrow in spite of yield curve inversion thanks to the abundant liquidity of petrodollar recycling.

as such, the collapse of oil prices (among other commodities) in recent days is quite possibly the beginning of the endgame for the 'petrodollar put'.

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