2007-08-26 - worst is over? or signal of worse things to come?

This is a list of some of the references I follow; 

The point of following these sources of information is to get further information to support my contention/conviction that what we have experienced is just the start, NOT the end, of such crises, and, as such, should be treated as an opportunity to reassess our outlook based on the now obvious reality -- that the housing market has not bottomed yet and won’t anytime soon; that the mess in sub-prime is NOT contained; that availability of credit cannot increase indefinitely; that credit has been THE driving force behind market outcomes; that credit is NOT going to be nearly as available as it has been; that leverage begets further leverage on the upside, but on the downside leads to de-levering, into a vicious circle; that U.S. consumption (over 70% of US GDP and 30% of world GDP) would be forced to recede when MEW disappeared, the wealth effect turned around, billions of mortgages reset at much higher levels, and the reality of insufficient income growth to support consumption growth became obvious, and households would be forced to rebuild their personal balance sheets; and that episodes of such extremes do not unwind quickly nor gracefully. 

 

To treat the recent stock sell-off as a buying opportunity would be to ignore all these fundamentals. So far, what the markets have experienced is a financial event and a liquidity event. Markets have not yet come to appreciate the weak underlying economic fundamentals, nor the extent of insolvency in the system. The markets may rally in the short-term from here, in particular when the Fed first eases, but the Fed will be impotent as it will, as per D.R., be pushing on a string, the fundamentals will become more obvious over time even to the most rosy-eyed commentators on CNBC, and markets will resume a nastier sell-off (bonds rally).

 

In any case, what the recent turmoil HAS done is resolve the one question that I could never accurately predict --- i.e. when exactly the markets would be forced to acknowledge the brewing credit crisis. (even if they’re now trying again to dismiss it) (I thought it wouldn’t be until they first acknowledged recession risks – ie a hard landing would force people to acknowledge the unsustainability of the debt buildup)

 

In any case, I don’t want you to take MY word for it. In the past, I have forwarded some material that I thought was crucial to understanding the mess the U.S. economy is in and to assessing likely outcomes (these have included Paul Kasriel on U.S. labour market and predictors of U.S. recessions; Contrary Investors’ Monthly Observations on the unsustainable build-up of debt in the system; UBS’ George Magnus’ research on Hyman Minsky’s predictions for the resolution of credit excesses; Bank of International Settlements’ warnings on similar; as well as my own research on payrolls and debt). 

 

I would now like to broaden my recommended reading list. All along, my views have been motivated not just by my understanding of the raw data, but also by reading a wide variety of non-mainstream commentaries (the only mainstream economist I’ve read that I believe has been saying the right things has been Rosenberg): 

 

Economists on economy:

- Paul Kasriel, Northern Trust economist (limited free access on NT website, but full access to his research pieces (with a lag) at http://www.safehaven.com/archive-142.htm) (there are other insightful pieces at safehaven as well, but unfortunately you have to sift through a lot of extreme crap)

- Nouriel Roubini, Professor of Economics at New York University's Stern School of Business, Chairman of RGE Monitor (free but not full access to his writings at his blog, http://www.rgemonitor.com/blog/roubini/ , can sign up for full RGE access)

 

Manager on stock market:

- Johh Hussman, PhD, formerly econ prof, now fund manager, (weekly commentary on state of stock market, especially, and bond market a bit as well, at http://www.hussman.net/weeklyMarketComment.html and more research at http://www.hussman.net/researchInsight.html) (in particular, read about his theory/condition of OVOBOBY – over-valued, over-bought, over-bullish, yields rising; as well as his criticism of the Fed model)

 

Daily insights (blog):

- Calculated Risk blog (http://calculatedrisk.blogspot.com/ ) for coverage of daily economic news, with special focus on housing

- Barry Ritholtz, manager (daily blog http://bigpicture.typepad.com/ ) 

- Minyanville (http://www.minyanville.com/ )

- Tim Iacono’s blog (http://themessthatgreenspanmade.blogspot.com/ )

- Michael Nystrom’s blog Bull, Not Bull (http://www.bullnotbull.com/bull/ )  

 

 

More viewpoints from managers:

- John Mauldin, manager, and guests (writes his own weekly commentary, Thoughts from the Frontline, plus has a weekly guest commentary, Outside the Box, both available via email through free registration, plus available online at http://www.investorsinsight.com/ )  

- Contrary Investor Monthly Observations (which I forwarded in PDF earlier; http://www.contraryinvestor.com/mo.htm)

- Comstock Funds’ weekly commentary http://www.comstockfunds.com/index.cfm/MenuItemID/185.htm

- Wilfred Hahn, Hahn Investment Partners: (most available here: http://www.hahninvest.com/global_spin.php, but more here: http://www.safehaven.com/archive-179.htm )

- Eric Sprott monthly Markets At A Glance article (http://www.sprott.com/marketoutlook/marketsataglance.php )

- Bill Fleckenstein’s Contrarian Chronicles (he has a subscription site, but his abridged views are available weekly for free at http://articles.moneycentral.msn.com/Investing/ContrarianChronicles/ContrarianTodayButTomorrowWhoKnows.aspx )

- Priur de Plessis (http://investmentpostcards.wordpress.com/ )

 

 

And, finally, probably the most bearish/extreme of the bunch, but with lots of documentation to support his views:

- Mike Shedlock aka mish (http://globaleconomicanalysis.blogspot.com/)  

 

If you want to start with just a few, I’d recommend reading everything you can by Kasriel, Roubini and Mish (and perhaps calculated risk)

 

Others to listen to, not via online blogs, but in their Bloomberg interviews, etc., would include:

-        Gary Shilling

-        Warren Buffett

-        Dr. Robert Shiller

-        Jeremy Grantham

-        Marc Faber

-        Dennis Gartman

-        Jim Rogers

-        Bob Prechter (you don’t have to believe in his Elliot Wave Theory hocus pocus to agree with his insights on the fundamental backdrop to the economy/markets)

-        Dick Bove (e.g. see Aug 20 interview on BBTV)

-        David M. Walker, the Comptroller General of the United States and head of the U.S. Government Accountability Office

-        Andy Xie (formerly of MS, but walked away when he was criticized for being too outspoken)

-        Stephen Roach (since he moved to head up MS’ Asia unit, his semi-weekly commentaries are no longer available, but 

 

 

The above authors have been unanimous in their below consensus views on the U.S. economy (none are perennial bears (except for maybe Roach); they’re realists that have gotten bearish due to their interpretations of the fundamentals) but their predictions for outcomes (both the economy and markets), while unanimously cautious/defensive/negative, have gone to varying extremes, from relatively short-lived (harder landing than consensus, but recession not definitive; global economy will decouple from U.S.; stocks sell off temporarily but then resume upward course) to very nasty (long bear market; recession for sure, deflationary depression likely as well; global)

 

My understanding of the economic data and my understanding of the above authors’ writings has led me to conclude that:

- the U.S. economy will soon be in recession, if it is not already (not withstanding Q2 revisions to 4%+ GDP)

- the U.S. economy is now experiencing a Minsky Moment, which will have far-reaching and long-lasting impacts as all the leverage that has built up gets unwound, in each of the financial, household, corporate and, over a much longer timeframe, even government sectors

- corporate profitability and low default/bankruptcy rates have been sustained by access to cheap credit, which will be a thing of the past (even when the Fed cuts, as having a pulse won’t be enough to be approved, and spreads will be higher), and mean reversion will set in

- the global economy may appear to “decouple” for a time, but it will become apparent with a lag that what has driven global economic growth has been furnishing the U.S. consumer with all its possible needs/wants/desires, and a consumer-led U.S. recession will ultimately drag global economy down too, albeit with a lag

- the bull stock market is over; the bear market will not be measured in months but years

- U.S. treasuries and the USD will initially benefit from a flight to “quality”, but a renewed focus on at least the twin deficits and a likely new appreciation of the miserable state of U.S. government finances (see Walker at GAO) could put that bond rally at risk, especially if foreign buyers of USD start trying to get out before their counterparts, causing a snowball effect

- a deflationary depression is a distinct possibility that we should be considering as a potential outcome (this is more like Japan 16 years ago than people are willing to admit)

 

M

 

 

p.s. Once upon a time, not so long ago, these views were considered extreme, if not ridiculous:

- there was a bubble in housing (Jun06)

- housing would enter a long recession (Sep06)

- there would be a related financial crisis, a la S&L (Sep06)

- housing was not bottoming anytime soon (Oct06/Jan07)

- subprime mess would not be contained (Feb07)

- there would be a credit crunch (Apr07)

- all of these would negatively impact consumers, with impacts first obvious in housing and autos, but expanding broadly from there

All of these once-Chicken Little-theories are precursors to the yet-proven predictions above. It doesn’t mean the worst of my predictions is a sure thing, by any means, but I hope it means that they’re worth considering at least as seriously as the views of those who, motivated by Malpass, Kudlow, Wesbury and the other optimists, continue to be blasé about the downside risks --- and means the burden of proof should be at least as much on the optimists as the pessimists.

p.p.s. at D.R.’s suggestion, I’m now reading Charles Kindlebergh’s book “Manias, Panics and Crashes” – I’m sure it’ll be instructive

 

2007-08-12 - Roubini: WE ARE FACING A “FUNDAMENTAL DEBT, CREDIT AND INSOLVENCY CRISIS”, NOT JUST A LIQUIDITY CRUNCH

NOURIEL ROUBINI’S INSIGHTS INTO THE CURRENT MARKET TURMOIL: WE ARE FACING A “FUNDAMENTAL DEBT, CREDIT AND INSOLVENCY CRISIS”, NOT JUST A LIQUIDITY CRUNCH


“(T)he vicious circle of a weakening US economy – with a housing recession getting worse and a fatigued consumer at the tipping point - and a generalized credit crunch has sharply increased the probability that the US economy will experience a hard landing.”



New York, NY August 10th, 2007 – RGE Monitor chairman and NYU/Stern School of Business professor Nouriel Roubini has provided analysis of the current precipitous declines seen throughout the global markets in his blog posting, “Worse than LTCM: Not Just a Liquidity Crisis; Rather a Credit Crisis and Crunch.”

Professor Roubini argues that the current market turmoil will be much worse than the crises of the late 1990s – such as the LTCM liquidity crunch - for several reasons. “Today we do not have only a liquidity crisis like in 1998; we also have a insolvency/debt crisis among a variety of borrowers that over-borrowed excessively during the boom,” Professor Roubini observes. “You have hundreds of thousands of US households who are insolvent on their mortgages. . . lots of insolvent mortgage lenders. . .(and) soon enough – plenty of insolvent home builders,” he adds. “We also have insolvent hedge funds and other funds exposed to subprime and other mortgages.” And even in the corporate sector default rates – that have been kept unusually low until now by excessively easy credit conditions – will sharply increased now that risk has been repriced and corporate yield spreads are much higher.

Combined with other fundamental economic factors, Professor Roubini argues the result is likely to be a hard landing for the U.S. economy, most likely a “growth recession” where growth stagnates below 1% for several quarters. He concludes, “The risks of a systemic crisis are rising: liquidity injections and lender of last resort bail out of insolvent borrowers - however necessary and unavoidable during a liquidity panic – will not work; they will only postpone and exacerbate the eventual and unavoidable insolvencies.”

The full posting follows below and can also be accessed at www.rgemonitor.com/blog/roubini <http://clicks.skem1.com/v/?u=6ba697a1d304a7d2cba0e87f4a9375e6&g=1088&c=444&p=f22026063a61ca80e83cb037b76b4e84&t=1> . For commentary and analysis from Nouriel Roubini, RGE Monitor Chief Economist Brad Setser and numerous other well-known economists, please visit www.rgemonitor.com <http://clicks.skem1.com/v/?u=97d5b64d6f23a8f41769c825c4ccd7db&g=1088&c=444&p=f22026063a61ca80e83cb037b76b4e84&t=1> today.


Worse than LTCM: Not Just a Liquidity Crisis; Rather a Credit Crisis and Crunch

Nouriel Roubini | Aug 09, 2007

The global market turmoil got ugly today forcing the ECB and the Fed to inject liquidity in the financial system as the concerns about subprime, credit and debt turned into a full blown liquidity run and crisis. As in 1998 at the time of the LTCM crisis, the Fed and global central banks decided to ease monetary policy in between meetings and injected a large amount of liquidity into the system. Coming two days after the Fed tried to prevent perceptions of a "Bernanke put" by signaling in its FOMC statement no Fed easing and no bail out of the financial system, the Fed actions today are certainly ironic if necessary given the massive liquidity seizure in the financial markets.

But the current market turmoil is much worse than the liquidity crisis experienced by the US and the global economy in the 1998 LTCM episode. Let me explain why. Economists distinguish between liquidity crises and insolvency/debt crises. An agent (household, firm, financial corporation, country) can experience distress either because it is illiquid or because it is insolvent; of course insolvent agents are – in most cases - also illiquid, i.e. they cannot roll over their debts. Illiquidity occurs when the agent is solvent – i.e. it could pay its debts over time as long as such debts can be refinanced or rolled over - but he/she experiences a sudden liquidity crisis, i.e. its creditors are unwilling to roll over or refinance its claims. An insolvent debtor does not only face a liquidity problem (large amounts of debts coming to maturity, little stock of liquid reserves and no ability to refinance). It is also insolvent as it could not pay its claim over time even if there was no liquidity problem; thus, debt crises are more severe than illiquidity crises as they imply that the debtor is insolvent, i.e. bankrupt, and its debt claims will be defaulted and reduced. In emerging market crises of the last decade, we had liquidity crises (i.e. a solvent but illiquid sovereign) in Mexico, Korea, Brazil, Turkey; we had debt/insolvency crises (a sovereign that was both illiquid and insolvent) in Russia, Ecuador, Argentina.

The 1998 LTCM crisis was mostly a liquidity crisis: the US was growing then at 4% plus, the internet bubble had not burst yet, we were in the middle of the "New Economy" productivity boom, households were not financially stretched and corporations were not financially stretched with debt either. In spite of those sound and solvent fundamentals the collapse of Russia – a country then with the GDP of a country such as the Netherlands – caused a global liquidity seizure and crisis of the type experienced by credit markets in the last few weeks: sudden demand for cash liquidity, sharp increase in the 10 year swap spread, sharp increase in the VIX gauge of investors’ risk aversion, liquidity drought in the interbank and euro-dollar market, deleveraging of highly leveraged positions, reversal of the yen carry trades. With the exception of the credit event in Russia, this was not a credit/insolvency crisis. And since it was a liquidity crisis the Fed easing – 75bps – was successful in restoring in a matter of weeks calm and liquidity in financial markets. Even that liquidity episode had painful credit fallout: it is not remembered by most but the entire subprime mortgage industry went bankrupt in 1998-99 following the LTCM liquidity crisis. So a liquidity shock event triggered massive credit events then.

Today we do not have only a liquidity crisis like in 1998; we also have a insolvency/debt crisis among a variety of borrowers that overborrowed excessively during the boom phase of the latest Minsky credit bubble <http://clicks.skem1.com/v/?u=d604ce80501f0ea1b28e877f82d917d7&g=1088&c=444&p=f22026063a61ca80e83cb037b76b4e84&t=1> .

First, you have hundreds of thousands of US households who are insolvent on their mortgages. And this is not just a subprime problem: the same reckless lending practices used in subprime – no downpayment, no verification of income and assets, interest rate only loans, negative amortization, teaser rates – were used for near prime, Alt-A loans, hybrid prime ARMs, home equity loans, piggyback loans. More than 50% of all mortgage originations in 2005 and 2006 had this toxic waste characteristics. That is why you will have hundreds of thousands – perhaps over a million - of subprime, near prime and prime borrowers who will end up in delinquency, default and foreclosure. Lots of insolvent borrowers.

You also have lots of insolvent mortgage lenders – not just the 60 plus subprime ones who have already gone out of business – but also plenty of near prime and prime ones. AHM – that went bankrupt last week – was not exposed mostly to subprime; it was exposed to near prime and prime. Countrywide has reported sharp losses not only on subprime lending but also on prime ones. So on top of insolvent households/mortgage borrowers you have plenty of insolvent mortgage lenders, subprime and - soon enough - near prime and prime.

You will also have – soon enough – plenty of insolvent home builders. Many small ones have gone out of business; now it is likely that some of the larger ones will follow in the next few months. Beazer Homes – a major home builder - last week had to refute rumors of its impending insolvency; but so did AHM a few weeks before its insolvency. With orders for home builders falling 30-40% and cancellation rates above 30% more than a few home builders will become insolvent over the next year or so.

We also have insolvent hedge funds and other funds exposed to subprime and other mortgages. A few – at Bear Stearns, in Australia, in Germany, in France – have already gone bankrupt or are near bankrupt. You can be sure that with at least of $100 billion of subprime alone losses – and most losses are still hidden given the reckless practice of mark-to-model rather than mark-to-market - many more will go belly up. In the meanwhile the CDO, CLO and LBO market have completed closed down - a “constipated owl” where “absolutely nothing moves” the way Bill Gross of Pimco put it. This is for now a liquidity crisis in these credit markets; but credit events will occur given that the underlying problem was not of of liquidity but rather one of insolvency: if you take a bunch of to-be-defaulted subprime and near prime mortgages and you repackage them into RMBS and then these RMBS are repackaged into various tranches of CDOs, the rating agencies may be using magic voodoo to turn those junk BBB- mortgages into AAA tranches of CDOs; but this is only voodoo as the underlying assets are going to be defaulted on.

Moreover, the recent sharp widening in corporate credit spreads is not just a sign of a liquidity crunch; it is a sign that investors are realizing that there are serious credit/solvency problems in some parts of the corporate system. Ed Altman <http://clicks.skem1.com/v/?u=72246836411a061376e8d24e2aa43c59&g=1088&c=444&p=f22026063a61ca80e83cb037b76b4e84&t=1> , a colleague of mine at Stern, is recognized as the leading world academic expert on corporate defaults and distress. He has argued that we have observed in the last few years record low default rates for corporations in the U.S. and other advanced economies (1.4% for the G7 countries this year). The historical average default rate for US corporations is 3% per year; and given current economic and corporate fundamentals the default rate should be – in his view - 2.5%. But last year such corporate default rates were only 0.6%, i.e. only one fifth of what they should be given firms' and economic fundamentals. He also noted that recovery rates - given default - have been high relative to historical standards.

These low default rates are driven in part by solid corporate profitability and improved balance sheets. In Altman’s view <http://clicks.skem1.com/v/?u=60d3c40f9d9fb6ae31562540efb585a5&g=1088&c=444&p=f22026063a61ca80e83cb037b76b4e84&t=1> , however, they have also been crucially driven - among other factors - by the unprecedented growth in liquidity from non traditional lenders, such as hedge fund and private equity. Until recently, their demand for corporate bonds kept risk spreads low, reduced the cost of debt financing for corporations and reduced the rate of defaults. Earlier this year Altman argued that this year "hot money" from non traditional lenders could move to other uses for a number of reasons, including a repricing of risk. If that were to occur, he argued that the historical patterns of default rates - based on firms’ fundamentals - would reassert itself. I.e. we are not in a new brave world of permanently low default rates. He said: "If we observe disappointing returns to highly leveraged and rescue financing packages, some of the hedge funds may find it difficult to cover their own loan requirements as well as the likely fund withdrawals. And broker-dealers who are not only providing the leverage to the hedge funds but whom are also investing in similar strategy deals will recede from these activities." The same could be said of the consequences of the unraveling of some leveraged buyouts. Altman suggested that triggers of the repricing of credit risk could also be "disappointing returns to highly leveraged and rescue financing packages". So he argued that the unraveling of the low spreads in the corporate bond market could occur even in the absence of changes in US and/or global liquidity conditions.

Thus, until recently the insolvent firms in the corporate sectors included corporations that could service their debt only by refinancing such debt payments at very low interest rates and financially favorable conditions. Many firms, under normal liquidity conditions, would have been forced into distress and debt default (either of the Chapter 7 liquidation form or Chapter 11 debt restructuring form) but were instead able to obtain out-of-court rescue and refinancing packages because of the most easy credit and liquidity conditions in bubbly markets. Now that we are observing a liquidity and credit crunch and a vast widening of credit spread you will observe a sharp increase in corporate defaults and a further risk in corporate risk spreads.

Insolvent and bankrupt households, mortgage lenders, home builders, leveraged hedge funds and asset managers, and non-financial corporations. This is not just a liquidity crisis like in the 1998 LTCM episode. This is rather a liquidity crisis that signals a more fundamental debt, credit and insolvency crisis among many economic agents in the US and global economy. Liquidity runs can be resolved by the liquidity injections by a lender of last resort: in the cases of the liquidity crises of Mexico, Korea, Turkey, Brazil that international lender of last resort was the IMF; but in the insolvency crises of Russia, Argentina, and Ecudaor the provision of the liquidity by the lender of last resort – the IMF – only postponed the inevitable default and made the eventual crisis deeper and uglier. And provision of liquidity during an insolvency crisis causes moral hazard as it creates expectations of investors’ bailout. Thus, while the Fed and the ECB had no option today but to provide massive liquidity in the presence of a most severe liquidity crunch and run, they should not delude themselves that this liquidity injections can resolve the deep insolvency problems of many overstretched borrowers: households, financial institutions, corporates. Insolvency/credit crises lead to financial and economic distress – hard landing of economies – and cannot be resolved with liquidity injections by a lender of last resort. And now the vicious circle of a weakening US economy – with a housing recession getting worse and a fatigued consumer being at the tipping point - and a generalized credit crunch sharply has increased the probability that the US economy will experience a hard landing. We are indeed at a "Minsky Moment <http://clicks.skem1.com/v/?u=27bf1c6ae34cacb1e1f427d18b542068&g=1088&c=444&p=f22026063a61ca80e83cb037b76b4e84&t=1> " and this recent financial turmoil is the beginning of a much more serious and protracted US and global credit crunch <http://clicks.skem1.com/v/?u=3b39a483f613089278d967db6d3ebfd7&g=1088&c=444&p=f22026063a61ca80e83cb037b76b4e84&t=1> . The risks of a systemic crisis are rising: liquidity injections and lender of last resort bail out of insolvent borrowers - however necessary and unavoidable during a liquidity panic- will not work; they will only pospone and exacerbate the eventual and unavoidable insolvencies.


Thursday evening update:

Countrywide, the US largest mortgage lender, announced that it faces "unprecedented disruptions" in the debt market and secondary market for mortgages that "could have an adverse impact on the company's earnings and financial condition, particularly in the short-term." Same for WaMu. This is a serious and scary development. As reported by Reuters <http://clicks.skem1.com/v/?u=1363303fc521c1c4d6e6224cc42170cf&g=1088&c=444&p=f22026063a61ca80e83cb037b76b4e84&t=1> :

Two of the largest U.S. providers of home loans, Countrywide Financial Corp (CFC.N: Quote <http://clicks.skem1.com/v/?u=92027c430f18a5c5f96853bf24433f0b&g=1088&c=444&p=f22026063a61ca80e83cb037b76b4e84&t=1> , Profile <http://clicks.skem1.com/v/?u=c9f66163fbdd668ea359996268e5523d&g=1088&c=444&p=f22026063a61ca80e83cb037b76b4e84&t=1> , Research <http://clicks.skem1.com/v/?u=edee18c196f42835ec74edc3014d968d&g=1088&c=444&p=f22026063a61ca80e83cb037b76b4e84&t=1> ) and Washington Mutual Inc (WM.N: Quote <http://clicks.skem1.com/v/?u=a2c673ed219e0791482154f4396f6d01&g=1088&c=444&p=f22026063a61ca80e83cb037b76b4e84&t=1> , Profile <http://clicks.skem1.com/v/?u=0a92bbedd9f2aaa5499fda7a5cd78efb&g=1088&c=444&p=f22026063a61ca80e83cb037b76b4e84&t=1> , Research <http://clicks.skem1.com/v/?u=405243e867f49acd970e9dbc918a0c50&g=1088&c=444&p=f22026063a61ca80e83cb037b76b4e84&t=1> ), on Thursday said difficult mortgage market conditions are likely to hurt operations in the near term.

Countrywide, the largest mortgage lender, said it faces "unprecedented disruptions" in the debt market and secondary market for mortgages. It said these "could have an adverse impact on the company's earnings and financial condition, particularly in the short-term."

Washington Mutual, the largest U.S. savings and loan, said liquidity in the market for less-than-prime home loans and securities backed by the loans has "diminished significantly." It said that while this persists, its ability to raise liquidity by selling home loans will be "adversely affected."

The lenders offered their assessments in quarterly reports filed with the U.S. Securities and Exchange Commission.