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Monday, July 28, 2008


disaster talk

a couple of articles today highlighting not the best case but the worst; not how we get out but what happens if we don't.

the july 25 commentary of kurt kasun at prudent bear, pointing out among other things the imminent approach of zero hour.

as least as frightening, frank veneroso via yves smith -- with an updated version of marc faber's figure 10.

Over the last year the U.S. has undergone the worst financial crisis in the three generations since that horrific episode of the 1930s. Even though we have had a severe financial crisis the ratio of total credit market debt to GDP keeps on rising. This could have occurred because government was socializing debt, but that has not happened yet.

Private debt to GDP rose as rapidly last year as it did before the onset of the financial crisis. It even rose in the first quarter of this year as the financial crisis intensified. But unlike the 1930s, when this ratio rose even though economic agents did not want it to rise because nominal income was falling, in this episode the private debt to GDP ratio has kept rising because fee hungry lenders continue to engage in expanding credit to profligate over-indebted borrowers. If one looks at this chart with a historic perspective it is clear that this ratio cannot keep on rising. But if you ask people in the market place whether we must go though a period in which credit falls sharply relative to income they will say that need not be. It is widely acknowledged that it has taken several units of debt to produce a unit of GDP in recent years.
[again -- zero hour approacheth -- ed.] Most people strangely assume that will be the case in the next recovery. The same attitudes hold for our policy makers. They do not talk about an eventual reduction of credit relative to income. They talk about providing new channels of credit to offset constricting ones; for example, expanding the lending of the GSEs to offset the falloff in securitizations. Can the moon shot in the debt to GDP ratio keep going on, like so many assume? Or has something happened that makes at least a reversal, if not mean reversion, imperative now?

veneroso explains that the tech bubble which yielded the housing bubble has now yielded the commodity bubble -- an impoverishing bubble which, by diverting cash flow from debt service, will amplify the other primary reason for imperative mean reversion: deep, widespread insolvency on a scale simply too big to bail. in short, serial bubble blowing is at an end.

It has been calculated from the flow of funds accounts that the ratio of aggregate mortgage debt to residential real estate value reached a peak of 50% when the home price and home finance bubbles reached their peak at the end of 2006. But the flow of funds accounts do not capture second and third mortgages. They do not capture the home equity loans that are in portfolios other than those of the commercial banks. There is a large “other” household debt item in the flow of funds accounts which includes various such claims against residential real estate collateral. I encountered one ratio calculated by the housing finance industry that suggested that, at the home price peak at the end of 2006, the aggregate loan to value ratio was 57%.....

If home prices fall nationwide by 35%, it follows that the average loan to value ratio will exceed 90%. About 30% of all residential real estate in value terms is without a mortgage. For all real estate with a mortgage, the distribution of mortgage indebtedness is very skewed. With the average loan to value ratio rising to almost 90%, a huge share of almost all mortgage debt will be deeply underwater. All studies show that when mortgages are well underwater there are defaults and foreclosures. This applies to the majority of mortgage debt classified as prime as well as the margin of mortgage debt classified as subprime. If home prices mean revert, the odds are high that in the shakeout that will follow the total credit market debt to GDP ratio will finally fall from its moon shot trajectory.....

even where bailouts on this scale are attempted, the likelihood of unintended onsequences -- both in crowding out private refinancing efforts and forcing an interest rate rise on american treasury creditworthiness concerns -- will be high.

moreover, the truth is that the system of finance is supported not by recapitalization alone but credit growth -- meaning the return to the behavior that got us into this mess -- a prospect that looks even more distant for the private mortgage market than for the inherently inflationary and precariously positioned GSEs, per doug noland. as such, asset values would likely continue to decline in an effort to return to normal valuations to income even in the advent of recapitalizations -- though perhaps the probability of undershooting would be mitigated.

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I really appreciate your work daily. Keep doing it. Make more people wise.


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