Friday, August 17, 2007
it's the loans
To bring us back to where we started, a great many Alt-A and Prime borrowers will lose their homes because they will be hopelessly underwater when they need to refinance 3 to 5 years from now. If they had borrowed with conventional mortgages as they did in the past, they would not be facing this mortgage reset timebomb, and they would simply ride out the Sub-Prime debacle just as many homeowners made it through the declines of the early 90’s. However, it is different this time. This time, the loans they have taken out are going to ruin them. It’s not the borrowers, it’s the loans.
this does something to explain why the "subprime problem" is NOT a subprime problem -- it is a mortgage problem, regardless of borrower quality, and it is going to be very severe and last several years.
the fed cut interest rates by an emergency 50 bp this morning as it dawned on them that the bounce instigated yesterday afternoon had not carried through to asian and european markets. the futures spiked -- after all, this is what "consequence-free" capitalists had been dying for all week -- but the bounce in the equity market does nothing whatsoever to fix the basic trouble underlying the liquidity crisis: the insolvency crisis.
until or unless the american government starts taking all the hundreds of billions of levered mortgage-backed securities and their derivative cdo's off the balance sheets of banks, investment houses, insurers and pension funds -- not to mention foreign central banks -- and converts it into treasury debt, the problem remains as intractable as it ever was. these institutions are sitting on immense amounts of bad debt -- something like $450bn in mortgage-backed assets without a market between american and european banks alone, for which there is now nearly no market.
and is even that a solution? what if the government issued $450bn in new treasury debt to bail out the banks, all of it backed by essentially nothing? would that not destroy the dollar? would that not finally compel treasury holders to sell as indiscriminately as they bought? is a bailout of such scope even possible without inflicting even greater economic damage than it would remedy? the savings and loan bailout of 1989 amounted to $157bn. anything that would begin to help would dwarf all precedent -- and we're talking only about relieving the pressure of these unsold securities on originating bank balance sheets. it would not even begin to address all the paper that has already been moved off to pension funds, insurance and reinsurance, banks, the commercial paper market.... the rmbs market is estimated at $6.5tn (that's trillion, not billion). when the san francisco examiner suggests that a trillion-dollar bailout would be target, i think they frankly underestimate the cost considerably. debt forgiveness on this scale has the potential of sending the united states into a weimar scenario -- where the issuance of government debt and currency cannot add to the money supply because every new issuance is counteracted by an even bigger drop in the value of the currency.
as this disaster plays itself out, prudent observers should pay attention to the dollar. what is going on -- deleveraging, defaulting, tightening -- amounts to a contraction of the money supply and a slowing of the velocity of money. it should be getting harder to find money. these forces are deflationary. the dollar should strengthen as it becomes rarer.
but it likely won't. capital flight -- if it truly takes hold -- would result in people selling american debt and dollars for their home currencies (yen, euro). the issuance of bailout debt (or even just the anticipation of as much) would worsen the situation. if that cycle gets to a point where further cash injections can't offset currency devaluation, we could see the kind of problems that make for interesting history books.