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Wednesday, May 5, 2010

Financial Dominoes

In February 2007 a mortgage company from Orange County California, New Century Mortgage, had its credit lines on Wall Street shut down. It could not borrow any money to fund mortgages in its pipeline. New Century was the second biggest subprime lender in the country and funded a little over $2 billion annually in mortgages. The overall mortgage market was funding approximately $1 Trillion annually so New Century was only 0.2% (zero point two percent, not two percent) of the overall market. As a whole the subprime mortgage market was approximately 10% of the total mortgage market.

Because of New Century's size and footprint in the subprime market its inability to capitalize for continued lending was big, big news on Wall Street. Big enough that the investment houses and credit lenders to the mortgage industry decided to take a ride down to the mortgage departments and sniff around their mortgage portfolios.

Hmmmm. It seems that the issues that led to New Century's credit drying up, high loan to values, stated income and assets, low credit scores, were fairly common factors in their subprime investments. Not a lot of equity created a difficult situation should the lenders need to foreclose, just a minor shift in the housing market and entire portfolios would be underwater.

Wait a minute. What's this? It appears our "conventional" and "prime" mortgages underwritten using Fannie Mae and Freddie Mac guidelines and automated underwriting have some common factors as well: little to no equity with mortgage debt up to 100% of the property values, no income or asset verification in the files, many files with no appraisals, no pricing adjustments for median credit scores, minor adjustments for low credit scores.

It appeared that much of the "prime" debt had similar aspects to the "subprime" debt and here is a major subprime lender losing its ability to obtain funds and going under. Uh-oh, time to worry.

The New Century domino fell and soon others followed through Greenpoint, Ameriquest, Countrywide, Lehman Brothers, Merrill Lynch, Washington Mutual, Wachovia, and on and on. The housing bubble was exposed as being built on cheap money due to low interest rates and low scrutiny due to loose underwriting guidelines. Cheap money and loose credit standards support expanding markets and prices. Like a balloon, once stretched it does not take something as sharp as a pin to pop it, any pressure will due. Pressure like a company in Orange County being unable to obtain credit and fund its pipeline of mortgage applications.

History provides lessons that cross many boundaries, unfortunately too often those who need to know and understand history feel lessons from history are confined to similar social, economic and political situations and occurrences. Not so, as we are about to learn from the lessons from the history of our housing, mortgage and credit markets in the last decade.

Many, perhaps most, Americans pay little attention to the daily news for what is happening within America. Others are engrossed in the economic, political, lately environmental and social news on the front page and leading the evening news. Most Americans are somewhat ignorant of international news, and even more unaware of the impact events across the oceans have on our country. Let's take a look at what is very big news.

First, instead of property value let's use the term Gross Domestic Product (GDP) and instead of mortgage let's say national debt. Instead of borrower income or debt to income ratio let's use budget deficit. For the mortgage market the higher the loan to value, i.e. the greater the percentage of the value of the home that is covered by a mortgage, the riskier the mortgage and the higher the interest rate for the borrower, or it should be higher. Further, if a borrower has a high income to debt ratio that means that his debts, his monthly payment obligations, are a high percentage of his income. High debt to income ratios are bad, low debt to income ratios are good.

In the 1970's Northern European countries began to coalesce under economic agreements to provide leverage and economies of scale to compete in a global marketplace dominated by the United States, the Soviet Union, Japan and increasingly China. Slowly the economic agreements led to the creation of the European Economic Community, the EEC. Economic policies and treaties were made that treated the EEC as one economic entity in negotiations with non-EEC trading partners. Trade barriers internally to the EEC were lifted. A stated objective became the union of the nations under more than just the economic umbrella but also political and social. Eventually the EEC evolved into the European Union, or EU.

Like most most economic and political organisms the EU had members that wanted to grow and expand. Countries on the outside looking in started making noise about equality, equity, fairness and European social justice. Fearful of looking like the Haves and shunning the Have Nots, the EU allowed in several countries with inferior economies and sketchy political stability and integrity; namely Portugal, Spain, Italy and Greece as they became members became the Have Nots in the Haves group. The theory being with the EU serving as an economic umbrella the economies of the marginal nations would be lifted and all of Europe would benefit.

The EU established elections for leadership and representation from member nations. A standard currency was established, the Euro, and individual currencies were discarded. The EU established not only economic policy but social, environmental and political as well.

As the EU was gaining power over sovereign nations' policies and laws, member nations governments became more and more extravagant in their expansion of services and entitlements. Government jobs in some countries almost outnumbered those in the private sector. Government spending grew rapidly and tax rates climbed to feed the spending.

Popping the housing, mortgage and credit bubbles in America was a sharp decline in housing prices in major markets. Suddenly credit portfolios had liabilities that exceeded asset values. As values declined, foreclosures and defaults increased, assets were sold at lower values, lower values led to more defaults and the spiral started.

Greece has a national debt that far exceeds its GDP, somewhere in the neighborhood of 125%. Basically its loan to value is upside down, like many American homeowners who purchased homes in 2006 or 2007 with 100% financing. Greece recently had a tough time selling any debt to finance its government, its credit lines dried up. Greece, on the very thin edge of massive defaults, needs a bailout to the tune of approximately $150 billion. Chump change for America given the bailouts we experienced in the past two years, but a staggering sum for the European Union.

Seeing that allowing Greece to fail is not in the best interests of the EU, nor themselves, the Germans have been working to provide a bailout for Greece. Problem is they want to make sure that if they do provide a bailout that Greece makes some changes. Changes that are not sitting well with many Greek citizens, changes like cutting the pay for government workers and entitlement payouts. Perhaps watching our bailout of General Motors with the massive pension and benefit payouts still looming in the future that will require further bailouts, Germany is wanting Greece to only come to the well for one drink. Greeks want the money with no strings attached.

Greece desperately needs the bailout funds as its borrowing rates on its bonds have ranged from 13% to 18% for short term notes (U.S. notes meanwhile are cruising between 1% to 3%). Further impacting Greece is the sizable downgrade in rating for their national bond issues from virtually everyone. The downgrades began before the latest crisis started boiling a few weeks ago.

Also downgraded recently have been the bonds of Portugal, Spain and Italy with Ireland moving in that direction. Each of the downgrades has been directly related to the national debt vis-a-vis national Gross Domestic Product, with the latter being higher than the former.

With member nations lining up to be bailed out more and more burden is placed upon those still working in Germany, France, the Netherlands, etc and politically fewer and fewer German autoworkers, French wine makers and Dutch cheese makers are willing to throw their Euros to the failing economies of EU member nations most of them did not want as part of the Union anyway. As more nations fly to the brink of economic chaos and fewer nations are able or willing to help them the dominoes across Europe start to fall.

Is there a bridge for the dominoes to cross the Atlantic? Already the Greek crisis in impacting our markets as the stock markets fluctuate wildly daily on news of bailouts (stocks rise) and concerns that bailouts won't work or are not available (stocks drop). The current beneficiary are U.S. borrowers as mortgage rates, and government bond rates, have stayed low and dropping through the crisis as investors park their money in the safety of American bond yields.

Back to that bridge. Europe's economic woes begin with national debt that exceeds national Gross Domestic Products, their mortgages are greater than their property values. Continued deficit spending by the EU countries creates less ability to pay back their over extended credit, resulting in higher interest rates they cannot afford but must borrow. Deficits that are too big and debt that is too high and Greece is leading several nations to the cliff of financial collapse.

In the United States we have a current national budget deficit (national we are not including the multitude of state deficits) is at $1.4 Trillion with future budget calculations projecting deficits up to or beyond $3 Trillion. Currently the U.S. GDP is at $14.4 Trillion and the U.S. national debt is at $13 Trillion, or 90% loan to value. Add interest and future deficits to the debt and we are quickly approaching national debt exceeding national GDP.

Would you loan $250,000 to someone who is spending 70% more than they earn on a home worth $275,000? If you purchase U.S. Treasury bills that is what you are essentially doing.

Greece, like New Century Mortgage, is the first domino to fall inside the bubble. Who is next and how many will fall?

DCS 05052010


Bob Schilling said...

Not a bad analysis. I'd argue that US GDP is likely to rise in the next several years, and that rising tax revenues will modestly improve the debt-to-gdp ratio. But it's still a problem. We need to get the trend line to reverse itself.

There's precedent, as there is for many things. We incurred more proportionate federal debt in WWII, and then paid it off with the proceeds of the ensuing economic expansion. That might happen here as well, though our current entitlement programs will make it a slower process.

If we were to reach a breakthrough, say in energy production -- and we're getting close in a couple of areas -- that would let us provide our own energy without constantly going upside down on our energy budget, it would help. Slowing the flight of manufacturing would help as well. Legalizing immigrants to collect the full tax burden from them would be a good step. Canceling expensive military weapons system might help, though I'm not sure if the net reduction is worth it. There are other incremental steps to take -- regulating and taxing a variety of "sin" services, including at least marijuana; charging market rates for mineral extraction from public lands; and charging shippers a compensatory rate, not only for port facilities, but for the support services needed to keep them working. We desperately need to find a less expensive, more effective way to educate children -- but that's another blog.

In addition to these items, I think we're probably going to have to raise the minimum Social Security retirement age to 65, and it seems likely that both Medicare taxes and premiums will go up as time goes on. Politicians don't like to talk about these, and my guess is they're going to play Pass The Hot Potato. But eventually....

The States are going to have to thin their pension plans. Retirement age will need to go up to at least 60, and maybe 62 (it's frequently 55 now). Police and Fire will be exceptions, but even they're going to need to take a 5-year hit, I think. That could be a big problem for firefighters, but we've got to do something or we'll all go broke. And we absolutely must find a way to educate children more efficiently.

In many if not most other areas, the States can't really cut effectively. So much of their funding comes from the federal government that they get leveraged hard if they cut back. Yes, there should and will be some symbolic stuff, but it won't really change any trend lines.

Some pump priming would be good, though, and we can all think of good ways to do that. No state taxes on small businesses for 5 years would be a nice place to start, and I'd be willing to be generous with the definition of "small." Waiving property transfer taxes for a year would help. How about a 6-month waiver on sales tax for large items such as furniture, boats & aircraft? The idea is to get the economy moving again. And the state would get property tax on the items once they were in the new owner's possession. The list goes on.

You mentioned the EU's prosperity -- much of that, I think, is derived from the formidable economic walls they've erected to protect their economies. Those walls, of course, were one of the primary reasons that countries like Greece and Portugal, who really didn't have the economic strength to join the EU, were so keen to do so.

And don't you think the Brits are chuckling in their light brown beer just about now? They've got all the benefits of EU membership, but they're not clinging to a sinking Euro. Of course, like us, they're up to their reserved British eyeballs in debt. It will be interesting and perhaps instructive to see how they deal with it.

Charles S said...

And who's watching China? Notice any changes in the Central Bank policies? Are these rate increases to protect China or control inflation?
Thank you Dennis and Bob for helping some of your readers to better appreciate what is going on and the impact of our global economy on our everyday lives.