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Tuesday, March 25, 2008


chinese and commodity bubbles have popped -- deflation taking hold

in the past year i've remarked on the excessive-liquidity-fueled asset bubble taking place in china.

it's now over. shares are down some 40% from the peak and still collapsing. the economist included a story on chinese shares in this week's briefing on the financial crisis. by the analysis of china economic review, there might be considerable downside remaining.

earlier in february i mentioned that it might be time to evacuate commodities. this is less certain -- wheat subsequently jumped over its february reversal to put in a manic double-top at 1300. it too has subsequently dived over 20% in just a week. commodities broadly have backed off over 10% in the last month. this is not clear -- there could be a rebound and late-stage blowoff as dumb money floods in through ETFs.

but recent action is indicative of massive leverage coming off the underlying securities as large speculators unwind borrowed positions.

the dollar has jumped in the last week but remains entrenched in a steep downtrend. if however it should catch a bid here and break out, in combination with continued deleveraging in commodities and chinese shares, as well as t-bill yields around 1%, the danger of an accelerating and self-feeding debt deflation cycle will no longer be a danger -- it will be a reality. there's already some serious discussion of a liquidity trap.

at the source of deflation, of course, is the housing market. paul mcculley in his latest missive calls such a deflationary spiral an immediate certainty unless government quickly steps into the breach to support housing and the banks that are mired in it. today's release from case-shiller -- a record 2.4% drop in january alone, down 10.7% YoY and 12.2% from peak in may 2006 -- certainly reinforces the idea that house price declines are accelerating. (prices in chicago fell 2.2% in january, 6.6% YoY and 7.2% from the peak in september 2006.) so does the continuing increase in REO. (chicago has become a national leader in foreclosed property.)

his favored measure is a forced writedown of mortgage principal balances -- one can describe buying a house with no money down as the cheap purchase of both a call option with maintenance cost (ie, the mortgage payment) and a free put option. if the house price appreciates, one can maintain the call option as it goes into the money by making mortgage payments. if the house price falls below the outstanding mortgage balance, however -- into a negative equity position -- the call option becomes worthless and the put option goes into the money. one can exercise the put by going to foreclosure. when house prices are falling steeply with little hope of a near-term rebound, then, it is quite sensible to quit the mortgage and lose the house -- particularly if you don't prize your credit rating.

by writing down the value of the mortgage so as to give the owner/option-holder positive equity, one keeps the put option from going into the money and incentivizes the maintenance of the call. the writedowns would be extremely painful for the investors, but as recovery in foreclosure is normally something like 50 cents on the dollar, many mortgage lenders would seem incentivized to write down loan balances.

mcculley presupposes much in this, and ignores the fact that tranched MBSs have high-quality asset holders who would be hurt by such a plan even as lower-quality asset holders would benefit. in other words, there will be resistance to any plan to write down mortgage balances. and he further does note the ethical problem of rewarding the dumbasses and conmen who took out these mortgages.

problems aside -- mcculley is fully aware that if millions of these put options go into the money, there is likely no avoiding the most powerful episode of debt-deflation in the united states since the great depression as we make the reverse minsky journey. there must be a large policy response.

none of that, however, is going to prevent house prices from restoring something like their traditional relationship to incomes and rents in the next few years. mcculley is simply describing a way that losses resulting from much lower prices can be nationalized.

Q: You don't see the housing market naturally hitting a place that will attract cash buyers, like California GOs?

A: Not nearby, if you will. Because you know that California GOs are money good; it's a pretty straightforward calculation to make. But with the property market, you don't have a terminal value known as par. So you're catching a falling knife. Unlike a bond that's going to mature at par, the falling knife in the property market doesn't have a maturity date on it. So you only get to that point, conceptually, when you get price-to-rent ratios down sufficiently that somebody could buy the house and rent it out and have positive carry. With me there? That would work only when I could buy a house for a carrying cost of 1300 bucks a month and rent it out at 2100 bucks a month. That's not the case in America now. It's all negative carry on property relative to what you can rent for. That would conceptually be your floor, but that is so far away from here that the economy would have to go through absolute hell to reach that point. Remember, if you're thinking, "Maybe I want to buy a property here," your second line of thought is probably: "Well, if 10% of the people have in-the-money puts now because they have negative equity, and they're exercising, the very exercise of those puts is going to drive prices down, so you will have another 10% of the people whose puts will go into the money.

Q: That deflationary spiral again.

A: It makes no sense to try to get in front of it, if you know that it's a self-feeding process on the way down. The key issue is that so much of the marginal lending in the last years of the boom was done with no skin in the game. It smells to high heavens and I'm sure that Mr. Bernanke didn't like having to say the words, but the only way that you can stop the process is, effectively, to write down the principal to the point that the guy's put is no longer in the money and his call is actually marginally back in the money. ...

mcculley goes on to note that, even after the government buys mortgages at a 25% discount from investors, the taxpayer is still at risk from further declines in housing. but it would be the taxpayers, and not the banks -- thereby at least relieving the pressure on the financial sector and avoiding the necessity of a wholescale deflationary meltdown.

there's no guarantees, of course -- if such a bailout were to precipitate a run on the dollar, rather than prevent one, the fed would be compelled as in 1931 to raise interest rates at the worst possible time. but i have to imagine mcculley is essentially correct as to what must be done to lessen the risks.

unfortunately, the bush administration is instead inclined to whistle past the graveyard. more from econbrowser on their abdication of responsibility in an election year. if this turns out ot be their final position and deflation accelerates into november, the administration may well solidify the claims of those who would call their tenure the worst presidency in the history of the united states.

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Would that not amount to a defaulting on debt held by China and Petroleum producing countries? Where would that lead?

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in the first analysis, anon, i'd think deflation would be a net positive to dollar-asset holders overseas. dollars will get scarce and the dollar should strengthen in currency markets -- effectively increasing the payout to dollar holders.

but if the response to avert deflation results in a run on the dollar, then yes -- a dollar collapse is a soft default.

there's an open debate as to what forex losses mean to foreign central banks, or whether such losses would cause them to guide policy. there's a presumption -- larry sumners called it the financial balance of terror -- that once losses or even volatility start exceeding certain thresholds, the balance is broken and large dollar holdlers will refuse to support american deficits and the dollar through continued vendor financing. but i don't know if anyone knows that that is true.

but if we get to that point, it means an inability for americans to import goods (including oil) and a very tangible decline in our standard of living.

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Yes but what about the position of writing down debt principle? The credit crisis is claiming victims as far away as australia already. What happens if this not only becomes even more prevalent, but USG sanctioned as well?

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right, i see your point now anon -- most FCBs hold agency debt, and i don't think that's in any jeopardy of writedowns -- indeed, fannie and freddie will be nationalized before that happens, imo, with USG eating the losses.

but foreign banks and private parties, like domestic investors in private-label MBS, would be taking the brunt of writedowns. the question is whether one can convince them that it is in their interests to do so -- that they actually will improve their recovery of capital. as it is, in many cases they have an illiquid security that may ultimately recover very little of its par value.

as mcculley says, there are no good choices now -- it's all about trying to find the least painful path to clearing prices. i expect, as you may as well, that there will be significant investor resistance to the idea of writedowns because 1) some don't recognize the depth of the problems facing their holdings, and 2) some high-quality MBS that are in good shape stand to be hurt by writedowns. this is why government intermediation would be necessary.

does it mean further asset-price deflation? yes -- this is debt liquidation by de facto default. but it may actually stem an even more severe wave of deflation that would do even more damage to investors.

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