Nouriel Roubini's Global EconoMonitor

Archive for February, 2007

  • Is the Sub-Prime “Garbage” 6% or Rather 50% of the Mortgage Market? And the Worst Housing Recession in Decades…

    Now even mainstream media and mainstream analysts regularly speak of the sub-prime “meltdown” or “carnage” and refer to these sub-prime mortgages as “garbage” or “trash”. Since most of these sub-prime mortgages were junk that should have never been originated in the first place, now the new spin in financial markets is to minimize the nature of the problem by making two arguments: first, sub-prime loans are only a very small fraction of the housing market, specifically only 6% of it; second, sub-prime problems are a niche problem that is not affecting other parts of the mortgage market. Both arguments are utter spin without any basis. Let us see why.

    Where did the Mortgage Bankers Association (MBA) get the “sub-prime is only 6%” figure that it is spinning around in every possible media? Their trick is to consider all homeowners, even the 35% of homeowners who do not have any mortgage and then argue that only 6% of homeowners are sub-prime borrowers. Why is this spin and why is the actual figure for “garbage” mortgages actually closer to 50% of the flow of new mortgages in 2005-2006 rather than the “6%” being spinned around? Several reasons.

    Let me elaborate:

    1. Sub-prime are now 13% of the stock of mortgages, not 6%.
    2. Sub-prime mortgages were at least 20% of mortgage originations in 2005 and 2006.
    3. The same “monster” lending practices used for subprime mortgages were also used for most “near-prime” and “prime” mortgages.
    4. Many pseudo “near-prime” mortgages (such as Alt-A) are undistinguishable from sub-prime ones and have now sharply rising default rates
    5. What is defined as sub-prime is subject to highly cosmetic accounting by banks: the rule that FICO scores of 660 or below are sub-prime is often diluted down to 630 or even 620 to exclude many mortgages from a sub-prime classification.
    6. Counting all of the categories above, subprime-like mortgages accounted for almost 50% of all originations in 2005 and 2006 not the 6% figure spinned by the industry lobbies.

    So whenever you hear the spin about the sub-prime meltdown not being such a big deal as “sub-prime mortgages” are only 6% of the housing market beware of such misleading spins. Properly measured sub-prime and near sub-prime and effectively sub-prime (because of creative accounting) mortgages accounted for almost 50% of all originations last year. So the mountain of “garbage” and “trash” that has been piling up in this sub-prime carnage includes a good half of new mortgages created in recent times. And the meltdown of these mortgages – both those that are formally sub-prime and those that are effectively sub-prime – will create a massive credit crunch in short order. At the end of the day “garbage” is garbage, whatever you name it. What is labeled as “Prime Garbage” stinks as much as the “Subprime Garbage”. And if it walks, ducks and quacks like garbage it passes the smell test of being garbage. Some of that garbage may rot more or faster than the rest but the overall state of the mortgage and housing market is the worst in decades.

    Also, note that with new home sales down 16.4% in January ( the biggest drop since 1994 as reported today) and housing starts down another 14% in January alone, both the demand and the supply side of the housing market are in literal free fall and collapse. The only things that are mushrooming in the housing market are cancellations (in the 30 to 40% range for major home builders) and the stock of unsold new and old homes that is at historically unprecedented highs. All this means home prices headed sharply south in the months ahead. As I argued last summer (see here and here and here) this is the worst housing recession in the last five decades. In a long paper with Christian Menegatti that I will publish next week I will flesh out in much detail the arguments on why the housing recession is nowhere close to bottoming out and why the housing recession will get much worse before it reaches any bottom.

    Instead, let me now go into some more detail about each of the above monstrosities on how “sub-prime” mortgages are measured and why the “garbage” in mortgages is closer to 50% of recent mortgages rather than 6%.

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  • Economic and Financial Hard Landing Ahead

    Today we had a meltdown of many stock markets, first in China, then in Europe, the U.S., emerging markets and globally. What happened today is consistent with my outlook for a U.S. hard landing this year. The China crash had its source in the stock market bubble in China that is now beginning to burst […]

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  • Durable Goods Orders Confirm that the “Investment Recession” is Worsening and a Hard Landing Is More Likely

    I have been arguing since last summer that, given the glut of housing and durable goods, we would observe a sharp contraction in real investment (i.e. investment in new capital goods) as the economy slows down and then has a hard landing.

    Most recently I pointed out again in a blog that, in addition to a worsening housing recession, auto recession and manufacturing recession we also have an “investment recession”:

    We also have an investment recession as almost all components of investment are falling: housing falling at a likely rate of 18% in Q1; corporate investment in software and equipment falling in Q4 and capital goods durable orders down for months now; inventory investment falling sharply; and now non-residential investment in structures (the only strong investment in 2006) is also on the verge of falling as its rapid growth earlier in 2006 (20% SAAR in Q2) slowed to a near stall crawl rate of 2% in Q4 with more weakness ahead.

    The data on durable goods orders today (falling much more than expected, for headline, core, and capital goods orders) confirm what has been obvious for months: in spite of “record” earrnings corporations are pessimistic about the future and they have stopped investing into new capital goods. No wonder: given the glut of capacity and of unsold goods, why to invest?

    And now earnings growth is decelerating at a very rapid rate: even Greenspan yesterday pointed out that this slowdown in corporate profits is a crucial signal in his call that a recession is possible by year end. And given these data the consensus that was putting real investment in software and equipment at an annual growth of 6% in Q1 looks increasingly meaningless. After falling at an annual rate of over 2% in Q4 (to be revised downwards tomorrow) it looks like equipment investment may be falling at an annual rate of 10% in Q1 rather than increase. Given the weakness in other components of aggregate demand (residential investment, inventories, consumption) a growth rate of GDP in Q1 close to a stall rate of 0% (something in the 0% to 1% range) is now possible if the current data on investment and consumption continue throughout the rest of Q1. So the risk of a hard landing of the economy is rising.

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  • Berner Says He Has Not Changed His Views on a Credit Crunch but He Actually Has and is Now Worried…

    At the Morgan Stanley house Steve Roach is the long-time bear while Richard Berner is the long-time bull. Given the wise ecumenical approach of Morgan Stanley to macro debates the two of them respectfully spar and disagree on most issues.

    Berner is one of the most thoughtful analysts in the soft landing camp. Two weeks ago Berner argued that the subprime “meltdown” and “carnage” (his words) would not lead to a widespread credit crunch. Today instead he says that he still believes that a general credit crunch will not occur but when you read his report he is actually changing his tone, hedging his views and presenting a laundry list of risks that may lead to a generalized credit crunch in the economy that would have serious consequences. The title of his piece “Credit Crunch Watch” says it all.

    It is good to hear that, after the WSJ editorial page and Greenspan warned about credit crunches and recession risks, now even the wise Berner is telling us why we may want to worry about contagion from subprime to other credit risks.

    Here is the important Berner piece followed by my views on the risks of a credit crunch and of a hard landing:

    Credit Crunch Watch
    February 26, 2007

    By Richard Berner | New York

    The subprime loan meltdown is still in full swing, and fears persist that it will usher in a broader credit crunch, spreading first to prime mortgages and ultimately to corporate credit.  Two weeks ago, I opined that the subprime crash is an idiosyncratic event unlikely to morph into a systemic crunch (see “Will the Subprime Meltdown Trigger a Credit Crunch?” Global Economic Forum, February 12, 2007).  I haven’t changed my view.  But I also believe that investors should watch indicators of credit quality and credit availability to assess the coming deterioration in credit quality, the reactions of lenders, investors, and policymakers, and the potential implications for financial markets.  A guide follows.

    The carnage in the subprime mortgage market seemed to intensify late last week, promoting a flight-to-safety bid for Treasuries as investors began to worry about spillover and contagion into prime loans and other asset classes.  According to Markit, the source for quotes on the ABX indices (the synthetic asset-backed benchmark indices referencing US sub-prime residential mortgages), the price of the lowest-rated on-the-run ABX 07-1 BBB- index plunged to as low as 68 on Friday, representing a 30% collapse in the last five weeks and roughly consistent with spreads of 1300-1400 bp over Libor.  This slide began to pressure the highest-rated ABX 07-01 AAA index, which lost about a point in price on Friday afternoon; previously that index had been essentially immune.  Likewise, while subprime lender bankruptcies triggered a bloodbath in the share prices of even the better subprime lenders beginning in November, only last week did concerns begin to spill over into the share prices of prime lenders. 

    Those worries are understandable, given soaring subprime defaults and the widely-publicized explosion in mortgage lending over the past few years.  But there’s no evidence yet of a broader deterioration in consumer credit quality or of spreading lender restraint.  Given healthy income growth, as I see it, aggregate consumer debt-servicing capacity remains healthy. 

    Nonetheless, the tails of the credit quality distribution are getting fatter, and consumer delinquencies and chargeoffs are rising.  According to Federal Reserve data, delinquency rates on residential mortgage loans have drifted up by 30 basis points since the end of 2004 to a still-low 1.71% at the end of the third quarter of 2006.  In addition to the deterioration in lower-rated mortgages, some of that increase likely is traceable to the shock to many borrowers from the Gulf Coast hurricanes in 2005 and to the seasoning of mortgage portfolios as footings slow from growth in the mid-teens to mid single digits.  Mortgage chargeoffs have edged up 4 bp to 11 bp.  By comparison, they rose as high as 44 bp in the 2000 recession.

    Fed data indicate that delinquencies on non-mortgage consumer loans at commercial banks have risen about 15 bp from their record lows at the end of 2005; most of this is traceable to a rise in credit-card delinquencies of about 60 bp to 4.11% over the same period.  S&P data for securitized card portfolios show virtually identical results.  This is hardly surprising, given the “adverse selection” in cards resulting from better-quality borrowers switching from credit card into mortgage credit over the past several years.  Seasoning of card portfolios as lending growth slowed also unmasked the underlying delinquency characteristics in such credit.  New bankruptcy laws effective in October, 2005 triggered a rush to file before more stringent criteria took hold, distorting the credit card chargeoff statistics, but it appears that chargeoffs will rise in line with delinquencies. 

    So far, lender restraint seems limited to mortgages.  Banks aren’t the primary originators of subprime loans, but the deterioration in subprime mortgage credit quality may have already triggered sharply tighter bank lending standards to individuals, judging by the Fed’s January Senior Loan Officer survey.  Sixteen percent of responding banks on net reported tightening lending standards for residential mortgages — the biggest surge since 1990.  There’s no question that some would-be subprime borrowers will not get access to credit in coming months or years, and indicators of credit availability bear close scrutiny.  Small wonder: That tightening move followed three years of easing lending standards at a time when regulators have been warning banks about risky lending.  In contrast, bank lenders have merely stopped loosening standards for non-mortgage loans, and a diffusion index of willingness to lend has dropped sharply but remains positive. 

    Meanwhile, corporate credit fundamentals are extremely favorable, although earnings growth is slowing sharply.  Nonfinancial corporate balance sheets were pristine at the end of Q3 2006: Credit-market debt in relation to net worth stood at 34-year lows, while long-term debt in relation to the total and “quick ratios” stand close to record levels.  Earnings growth, according to consensus estimates, is slowing from the double-digit clip of the past four years to mid single digits in the first half of 2007, but interest coverage ratios are still close to record high levels.  And delinquencies and chargeoffs at banks are still close to record lows despite a deceleration in lending, while junk and leveraged-loan default rates are at eight-year lows.  CDS, loan and bond spreads continue to tighten and lending standards remain loose.  The CDX default swap index of 125 investment-grade names narrowed to just 32 basis points last week, while BB/BB- leveraged loan and high-yield spreads have narrowed to record tights.

    Lenders, understandably against that backdrop, have stopped loosening their lending standards to corporate borrowers, according to the Fed’s Senior Loan Officer Survey.  Morgan Stanley bank analyst Betsy Graseck and I agree that corporate credit quality is as good as it gets, and there are some signs of weakness.  She reports that in 4Q 2006 the share of commercial and industrial loans 90 days past due rose 10% year over year.  She is expecting chargeoffs to remain flat this year, but loan provisions to rise 30% as falling recoveries spell the end to the long improvement in credit quality.

    For their part, regulators
    seem to be watching credit quality issues intently.  They’ve been warning against lax underwriting for several years, but unaccompanied by penalties or sanctions, those warnings haven’t deterred lenders from extending credit.  In part, that’s because liquid capital markets are enabling banks to sell down any positions in stressed loans.  That may now change.  The intensity of those warnings may rise as the subprime meltdown continues.  Even a slight reduction in market liquidity will make it more difficult efficiently to lay off risk, so lending standards will likely tighten further.  And while I think a regulatory overreaction to the abusive lending practices sometimes accompanying subprime lending is unlikely, regulators will press lenders to find the right balance.

    The financial market implications of these developments are straightforward.  Driven by performance imperatives, market participants may worry about spillovers from subprime woes into other asset classes, but they probably will take comfort from the resilience of markets to past shocks and continue to invest as if spillovers are unlikely.  The reality is that with still-favorable fundamentals, credit quality should deteriorate only slowly.  But the tails of the distribution are getting fatter, and investors should use the metrics just described to assess those increasing risks and move up the quality scale. 

    In these circumstances, investors should not confuse the resilience of consumers or businesses with ongoing stable credit quality.  For years, I‘ve argued that rising debt levels and credit risks would not trigger consumer retrenchment, but that the causality wouldn’t necessarily run in the other direction.  For example, two years ago, Dave Greenlaw and I wrote:

    “Record levels of consumer debt in relation to income have raised anew concerns that rising rates will undermine home and asset prices, forcing consumer retrenchment and increased thrift.  Rapid growth in subprime mortgage lending, much in adjustable-rate form, has seemingly heightened the risks.  But in our view, concerns over consumer leverage are overblown and misplaced; we think that lenders to the consumer are more at risk than are consumers themselves [italics added].  Our colleague David Miles and we agree that the UK and US mortgage markets are quite different: Unlike their UK counterparts, for example, most US consumers have paid up for insurance against rising interest rates with fixed-rate mortgages (see “Markets at Risk, Economy Resilient,” Global Economic Forum, January 10, 2005).” 

    “In contrast, US consumer lenders are exposed to rate and credit risks.  The consumer has three puts back to the lender, and we believe that lenders typically underprice those puts in their eagerness to book income.  There is an interest-rate put: Lenders (including investors) profit from the premiums that consumers are willing to pay to finance with fixed rates.  But the value of those options falls, and financing costs rise, when rates go up.  There is a “refi” put: Consumers can refinance at low cost, but lenders bear the optionality risk in both directions when rates change.  And there is a credit put: Overleveraged consumers may suffer financial consequences, but the average consumer suffers little.  But for the lenders, the tails matter; they suffer the income loss on nonperforming assets and the principal loss on default.  And lenders suffer from adverse selection when better credits pay down debt.”

    Likewise, there is an important dichotomy between the risks to markets and those to the economy from a deterioration in credit quality.  Financial innovation such as the structured credit and ABS markets have dispersed risk more broadly, thus increasing the resilience of the financial system and increasing the apparent resilience of markets to shocks.  The risk is that if liquidity ebbs, that apparent market resilience will also dwindle.  So while the subprime meltdown is likely to remain idiosyncratic, it should remind investors to carefully reassess lender credit quality and monitor risk-free spreads closely for any signs of distress selling or inability to roll over maturing paper, as well as the tone of rating-agency commentary that may affect ability to finance.


    As for my views, the readers of this blog know it well as I have expressed it in a over dozen blogs in the last two weeks; in brief I expect a worsening credit crunch that will trigger the vicious cycle that will lead to a hard landing of the economy. Here is a summary of  my views in some detail…

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  • Greenspan Warns of the Risk of a Recession by Year End

    After minimizing the risks of a housing recession – he claimed last year that the housing recession was bottoming out – now Greenspan is worried about a recession in the US by year end. As even the WSJ editorial page has recently warned about the risk of the housing credit crunch leading to a recession […]

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  • The BBB- rated portions of ABX contracts are “going to zero”…And the “Subprime Carnage” Worsens…

    The two panicky statements above (The BBB- rated portions of ABX contracts are “going to zero” and “subprime carnage“) are not mine. The “carnage” metaphor was used today by the usually sober and not panic-prone Wall Street Journal (and used interchangeably in recent days with the “meltdown” term by other mainstream media and analysts). While the former statement comes from the head of a securities brokerage cited today by Bloomberg

    The BBB- rated portions of ABX contracts are “going to zero,” said Peter Schiff, president of Euro Pacific Capital, a securities brokerage in Darien, Connecticut. “It’s a self- perpetuating spiral, where as subprime companies tighten lending standards they create even more defaults” by removing demand from the housing market and hurting home prices, he said.

    Taken literally the statement above is an obvious and clear exaggeration as ABX prices are nowehere close to zero. But from a substantial point of view – and as a metaphor of that ABX market – the statement is actually correct as prices of ABX BBB- indices are literally in a free fall. At the current asymptotic rate of fall (see charts here) they could in principle reach zero in a short time. For example the price of the ABX-HE-BBB- 06-2 – that was trading close to par (100) between August and Nobember 2006 – is now down to 72.71. The price fall since November could  be well described by an exponential hyperbolic function (a “free fall of the cliff” in the layman’s language of those who do not have a Ph.D. in finance). And at this rate of price fall of course – as argued by Mr. Schiff – prices are “going to zero”.

    But you do not need to reach zero to have an sub-prime “carnage” or “meltdown” (the latter term used – among many others – by the smart and still bullish Richard Berner of Morgan Stanley): even at the current price of 72 the cost of insuring against default on the riskiest tranches of subprime mortgages is already literally astronomic, having surged from the 50bps over Libor of a few weeks ago to the 1200bps plus (and rising by the hour) in recent days.  To cite Bloomberg:

    Subprime Mortgage Derivatives Extend Drop on Moody’s Reviews

    By Jody Shenn and Shannon D. Harrington

    Feb. 22 (Bloomberg) — The perceived risk of owning low- rated subprime mortgage bonds rose to a record for a fifth day after Moody’s Investors Service said it may cut the loan servicing ratings of five lenders.

    An index of credit-default swaps linked to 20 securities rated BBB-, the lowest investment grade, and sold in the second half of 2006 today fell 5.6 percent to 74.2, according to Markit Group Ltd. It’s down 24 percent since being introduced Jan. 18, meaning an investor would pay more than $1.12 million a year to protect $10 million of bonds against default, up from $389,000.

    Moody’s said late yesterday that it may cut the so-called servicer ratings for affiliates or units of lenders including Irvine, California-based New Century Financial Corp., the second- largest lender to subprime borrowers. Declines in the ABX-HE-BBB- 07-1 and similar indexes accelerated this month as New Century and HSBC Holdings PLC, the biggest lender, said more of their loans were going bad than they expected. London-based HSBC today said the head of its North American unit stepped down.

    “I do not think it is surprising we have trouble in this sector of the market; I think the surprise is the speed at which it has unfolded in the last couple of months,” said Mary Miller, director of fixed-income at Baltimore-based T. Rowe Price Group Inc., which manages about $335 billion in assets…

    Moody’s Review

    “Protection-sellers largely have stepped away until the market settles down,” Peter DiMartino, asset-backed securities strategist at RBS Greenwich Capital, wrote in a note to clients today. “Recent mini-rallies were just a few brave souls hoping they could actually catch the falling knife.”

    Moody’s said it also may reduce servicer ratings of affiliates or units of Ameriquest Mortgage Co., Accredited Home Lenders Holdings Co., Winter Group and NovaStar Financial Inc., which this week reported a surprise fourth-quarter loss of $14.4 million. The ratings affect how much protection for mortgage bond investors ratings firms require. Potentially weaker servicing at the companies may hurt existing bonds, Moody’s said…

    The level of delinquencies and defaults on subprime mortgages made last year is the highest ever for such loans at a similar age, according to New York-based Bear Stearns Cos.

    `Taken a Hit’

    Concern about low-rated subprime mortgage bonds have caused yield premiums to rise on low-rated bonds of so-called collateralized debt obligations backed by the debt. Yields on typical BBB bonds from such CDOs widened 1 percentage point relative to benchmarks in the week ended Feb. 15 to 5.50 percentage points, according to JPMorgan Securities Inc.

    “Liquidity has taken a hit as market participants wait for the dust to settle,” Christopher Flanagan, an analyst at New York-based JPMorgan, wrote in a Feb. 20 report. CDOs buy loans, bonds and derivatives, and resell the cash flows in new bonds, some of which have higher credit ratings…

    Low-rated subprime bond prices are getting to the point where Kirby said he may need to “reassess” whether the yields are high enough to cover the risks.

    `Going to Zero’

    New series of ABX indexes are created every six months by securities firms including Bear Stearns, and Goldman Sachs Group Inc., and London-based Markit. They indicate prices for default swaps linked to 20 bonds, not prices for swaps on each.

    Besides bondholders, stock investors have used ABX contracts as a way to bet on the declining fortunes of subprime mortgage companies or the housing market.

    The BBB- rated portions of ABX contracts are “going to zero,” said Peter Schiff, president of Euro Pacific Capital, a securities brokerage in Darien, Connecticut. “It’s a self- perpetuating spiral, where as subprime companies tighten lending standards they create even more defaults” by removing demand from the housing market and hurting home prices, he said.

    This ABX and sub-prime “carnage” is bad enough. However, the most interesting macro question is how this “carnage” will affect the credit crunch that is now hitting sub-prime mortgages and that is at risk of spilling over to other mortgages and to other credit spreads? Let us think in some detail about this most important question…(and those of you who are not RGE subscribers can watch my views on these issues in my recent interview on CNBC )

    [Friday Morning Update: The first five “Breaking News” on this morning are:


     Do you see any pattern here?]

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  • No bottom to the housing and mortgage meltdown: risk of an economic hard landing

    What can we make out of the latest housing and mortgage market news and analyses? What are the risks of a hard landing of the economy? Here is is a list of recent news and their implications for housing, mortgages and the economy. Over 22 subprime lenders closing shop in the last two months; subprime […]

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  • The WSJ Editorial Page Worries About a “Credit Crunch” and a “Recession”

    The Wall Street Journal editorial (op-ed) page is not used to expressing economic alarmism and worrying about hard landings and recessions. Its respectable – if debatable –  economic conservative philosophy is that, as long tax rates are kept low (supply side economics), regulation and government interference kept at a minimum, and government spending kept as low needed, the economy will grow at a sustained rate. For years now this WSJ page has criticized those who worry about fiscal deficits, current account deficits, financial risks and hard landings of the economy.


    So it was something of a surprise that, on Saturday, the WSJ op-ed page – under the title “How Expansions Die: Credit Cracks in the Economic Foundation” made the argument – as in my Friday blog –  that the sub-prime mess may lead to a broader  credit crunch that may cause a recession. This alarmed analysis of the usually sober WSJ op-ed page is in stark contrast to most research and analysis on Wall Street where the conventional wisdom is still that this is still a niche problem and that there is little risk of contagion or of a wider credit crunch.


    In my blog I worried about the sub-prime meltdown affecting prime mortgages and consumer borrowing; about the risk of a wider credit crunch; and about the risks that the carnage in the ABX market may spread to other credit risks. Similarly, according to the WSJ op-ed page (underline added):


    “… we finally have a threat that really does bear watching — namely, a potential credit crunch precipitated by the housing downturn and rising default rates. As Federal Reserve Chairman Ben Bernanke noted in his Senate testimony this week, the economic damage from the real-estate slide has so far been contained to housing. But in addition to the pain that homebuilders have experienced, banks and mortgage brokers are increasingly feeling the pinch, especially in the sub-prime sector. And in a perverse sort of populism, lawmakers are making noises about reducing access to credit for the riskiest borrowers, which would only exacerbate the crunch and could help take the economy down into recession.


    I argued that it was unusual that a “credit cycle” would precede rather than follow the economic slowdown (the “real cycle”). The WSJ fully agrees on this reverse cycle where this time around the credit crunch is coming first and risks to cause a real economy recession:


    The delinquency rate on sub-prime mortgages, now above 10%, is near record levels. Banks that bought up those loans for securitization are now demanding to be repaid, meaning that smaller institutions who thought they’d sold off their exposure are finding themselves on the hook, in some cases forcing them into bankruptcy.This accumulation of bad loans represents a crack in the foundations of the recovery. Typically, a housing downturn and the credit problems that accompany it are a result of underlying economic weakness, rather than their cause. The economy slows, people lose their jobs and are forced to sell under duress lest they default. The distressed selling drives prices down. But in this case, it may work the other way around. 

    The WSJ then discusses how a virtuous credit and economic cycle (or a bubble fed by Fed policy as I argued before) is now turning into a vicious circle:


    The Fed’s remarkably easy monetary policy helped goose house prices over several years. In turn, a large number of first-time buyers took advantage of low mortgage rates, especially on adjustable-rate loans, to stretch their buying power in the hopes of leveraging their way up the home-buying ladder. But someone finally blew the dog whistle in late 2005, and the buying dried up.Now the housing market is flat to down across most of the country and loans with adjustable rates are adjusting upward. So even with unemployment low and the economy still humming, marginal buyers can suddenly find themselves forced to sell. And if they had little equity to begin with, they may not have much money left after they sell — if they can sell at all. If they can’t, they fall behind on their payments and the banks have to book the loans as delinquent.Thus does a virtuous circle caused by easy money turn vicious, and interest rates aren’t even all that high — at least not yet. The Fed’s concern over housing’s potential effect on the broader economy is no doubt one reason it has kept short-term rates at 5.25% for several months, despite signs that inflation risks remain.

    I worried about a potential contagion from sub-prime to other credit risk premia and suggested that the valid concerns of Congress about predatory lending may exacerbate the credit crunch. The WSJ agrees:

    The unknown is how far the credit contagion will spread. While rising, overall delinquency rates are still fairly low. But if banks continue to be hit by defaults, it may constrain their lending in other areas. Credit spreads, which have remained remarkably narrow, could widen. Meanwhile, Congress’s newfound preoccupation with “predatory lending” could, if it leads to changes in the law or in tough lending standards, increase the credit squeeze currently beginning to be felt. Decreasing consumer access to credit would in turn cast a pall over consumer spending and add another drag on the economy.We aren’t joining the partisans at certain newspapers who have predicted recession each of the last four years. The labor market remains healthy, the consumer resilient, business investment robust and equity markets buoyant. But this certainly is no time for Congress to add to the risks of a credit crunch by committing such policy blunders as raising taxes, imposing trade barriers or punishing foreign investment in the U.S. Secretary Hank Paulson has prudently been adding financial plumbing capacity at Treasury, and he will need it to limit any credit fallout.As for the Fed, we hope the tale Mr. Bernanke told Congress this week about perfect “soft landings” was right. But we also suspect that the Fed chief has his fingers crossed that the rest of the economy, at home and abroad, is strong enough to withstand the housing credit woes that the Fed did more than its share to inspire.

    So if the cautious, optimistic, generally Goldilocks-biased editorial page of the Wall Street Journal starts to worry about a credit crunch coming even before the economy has slowed down, worsening housing and mortgage problems, and about the risks of a recession other folks in financial markets may want to reconsider the tired arguments about sub-prime problems being a niche problem, about housing having bottomed out (can they still say that with a straight face when housing starts fell another 14% in January alone?), and about the risks of a credit crunch being “dramatically overblown”. It is time for a reality check: a credit crunch causing a hard landing of the economy is not a far fetched argument any more. The WSJ op-ed page worries about it. Maybe Wall Street will also start worrying about it.

    Indeed, the biggest risk right now is that these financial problems (sub-prime mortgage meltdown, ABX carnage, credit cr
    ) will cause an economic hard landing and a recession. Let me explain in the rest of this blog why the risk of a hard landing of the economy in 2007 is high…

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  • Sub-Prime “Meltdown”, ABX “Carnage” and the Risk of a “Credit Crunch”

    When growth optimists such as the wise Richard Berner of Morgan Stanley (not just Roach, their resident long term bear) start talking about a sub-prime and ABX “meltdown”; when the terms “carnage” and “time bomb” are used by mainstream observers to describe the sub-prime and ABX market; and when the same Berner needs to write a long piece to convince you that there will be no “credit crunch” following the sub-prime meltdown you know that some serious trouble may be brewing. The trouble takes the form of three problems:


    1. Risk of the subprime “meltdown” becoming contagious to prime mortgages;
    2. Risk of the beginning of a broader credit crunch;
    3. Risk of the ABX “carnage” leading to more serious losses and implications for credit markets.

    Of course last week many investment banks had conference calls to reassure their clients with the message that the subprime meltdown is contained, that other credit spreads are holding in spite of the free fall of the ABX (BBB-) indices, and that there is very little risk of a broader credit crunch.


    That optimistic scenario is of course possible and we do not know yet how these credit markets will behave over the next few months. But the same cycle of minimizing the potential risks from the housing fallout has occurred all along since last year: the housing recession was first defined as “housing slowdown” and is now argued to be “bottoming out” based on relatively little evidence; today’s subprime “meltdown” was yesterday’s subprime “correction”; and today’s worries of a “credit crunch” are widely dismissed as unlikely.


    But consider the following issues. Normally when a sector like housing or real estate or tech goes into a boom and bust cycle, the “real cycle” precedes the “credit cycle”. In other terms we would have expected that weakness in housing would lead first to large job losses, lower income generation, higher unemployment first (the “real” cycle). Only when the “real” cycle is underway one would usually expect – as in the 1980s S&L fiasco – that a “credit” cycle would be triggered and emerge leading to further real and financial distress.


    Instead the most surprising thing about this housing bust and subprime meltdown is how the “credit” cycle started much earlier than the “real” cycle and much more rapidly than anyone would have ever suspected. Now in an economy with still high growth, still high job creation, still very low unemployment rate, still high income generation we are already observing massive increases in subprime defaults and foreclosures, 20 subprime lenders going out of business in two months, the ABX going into free fall and the cost of insuring against the BBB- tranche of the ABX index going to a spread relative to LIBOR of over 1000bps. So, if all this happening in what the consensus terms as a “Goldilocks economy” what would happen if the economy – as likely – will start to slow down more in 2007? How much more carnage can we expect in many sectors and markets when the economy is weaker than in recent months?  


    The fact that the downward “credit” cycle has emerged so fast and so sharply in a still “strong” economy is the most important signal that this sub-prime mess cannot be easily dismissed as a niche problem that will have no contagious effects on the rest of the economy and of financial markets.


    So let me explain in detail why there are meaningful risks that sub-prime meltdown could infect prime mortgages, why we could be at the beginning of a more serious credit crunch for consumers, and why there is a risk that the ABX carnage could spillover to other credit markets…


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  • The Latest Macro News

    Here are the latest macro news, mostly weak but with a few good spots: – January retail sales unchanged (0%) relative to December. Likely payback from the holiday splurge (in spite of gift certificates that should have boosted January sales)? Is the US consumer fatigued and at the tipping point given its high debt burdens […]

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