Friday, March 16, 2007


Roach Blames Greenspan


The Great Unraveling
March 16, 2007

By Stephen S. Roach | from Beijing

From bubble to bubble – it’s a painfully familiar saga. First equities, now housing. First denial, then grudging acceptance. It’s the pattern and its repetitive character that is so striking. For the second time in seven years, asset-dependent America has gone to excess. And once again, twin bubbles in a particular asset class and the real economy are in the process of bursting – most likely with greater-than-expected consequences for the US economy, a US-centric global economy, and world financial markets.

Sub-prime is today’s dot-com – the pin that pricks a much larger bubble. Seven years ago, the optimists argued that equities as a broad asset class were in reasonably good shape – that any excesses were concentrated in about 350 of the so-called Internet pure-plays that collectively accounted for only about 6% of the total capitalization of the US equity market at year-end 1999. That view turned out to be dead wrong. The dot-com bubble burst, and over the next two and a half years, the much broader S&P 500 index fell by 49% while the asset-dependent US economy slipped into a mild recession, pulling the rest of the world down with it. Fast-forward seven years, and the actors have changed but the plot is strikingly similar. This time, it’s the US housing bubble that has burst, and the immediate repercussions have been concentrated in a relatively small segment of that market – sub-prime mortgage debt, which makes up around 10% of total securitized home debt outstanding. As was the case seven years ago, I suspect that a powerful dynamic has now been set in motion by a small mispriced portion of a major asset class that will have surprisingly broad macro consequences for the US economy as a whole.

Too much attention is being focused on the narrow story – the extent of any damage to housing and mortgage finance markets. There’s a much bigger story. Yes, the US housing market is currently in a serious recession – even the optimists concede that point. To me, the real debate is about “spillovers” – whether the housing downturn will spread to the rest of the economy. In my view, the lessons of the dot-com shakeout are key in this instance. Seven years ago, the spillover effects played out with a vengeance in the corporate sector, where the dot-com mania had prompted an unsustainable binge in capital spending and hiring. The unwinding of that binge triggered the recession of 2000-01. Today, the spillover effects are likely to be concentrated in the much large consumer sector. And the loss of that pillar of support is perfectly capable of triggering yet another post-bubble recession.

The spillover mechanism is hardly complex. Asset-dependent economies go to excess because they generate a burst of domestic demand that outstrips the underlying support of income generation. In the absence of rapid asset appreciation and the wealth effects they spawn, the demand overhang needs to be marked to market. The spillover is a principal characteristic of such a post-bubble shakeout. Interestingly enough, in the current situation, spillovers have first become evident in business capital spending, as underscored by outright declines in shipments of nondefense capital goods in four of the past five months. The combination of the housing recession and a sharp slowdown in capex has pushed overall GDP growth down to a 2% annual rate over the past three quarters ending 1Q07 – well below the 3.7% average gains over the previous three years. Yet this slowdown has occurred in the face of ongoing resilience in consumer demand; real personal consumption growth is still averaging 3.2% over the three quarters ending 1Q07 – only a modest downshift from the astonishing 3.7% growth trend of the past decade.

Therein lies the risk. To the extent the US economy is now flirting with “growth recession” territory – a sub-2% GDP trajectory – while consumer demand remains brisk, a pullback in personal consumption could well be the proverbial straw that breaks this camel’s back. The case for a consumer spillover is compelling, in my view. A chronic shortfall of labor income generation sets the stage – real private compensation remains over $400 billion below the trajectory of the typical business cycle expansion. At the same time, reflecting the asset-dependent mindset of the American consumer, debt and debt service obligations have surged to all-time highs whereas the income-based saving rate has dipped into negative territory for two years in a row – the first such occurrence since the early 1930s. Equity extraction from rapidly rising residential property values has squared this circle – more than tripling as a share of disposable personal income from 2.5% in 2002 to 8.5% at its peak in 2005. The bursting of the housing bubble has all but eliminated that important prop to US consumer demand. The equity-extraction effect is now going the other way – having already unwound one-third of the run-up of the past four years. In my view, that puts the income-short, saving-short, overly-indebted American consumer now very much at risk – bringing into play the biggest spillover of them all for an asset-dependent US economy. February’s surprisingly weak retail sales report – notwithstanding ever-present weather-related distortions – may well be a hint of what lies ahead.

It didn’t have to be this way. Were it not for a serious policy blunder by America’s central bank, I suspect the US economy could have been much more successful in avoiding the perils of a multi-bubble syndrome. Former Fed Chairman Alan Greenspan crossed the line, in my view, by encouraging reckless behavior in the midst of each of the last two asset bubbles. In early 2000, while NASDAQ was cresting toward 5000, he was unabashed in his enthusiastic endorsement of a once-in-a-generation increase in productivity growth that he argued justified seemingly lofty valuations of equity markets. This was tantamount to a green light for market speculators and legions of individual investors at just the point when the equity bubble was nearing its end. And then only four years later, he did it again – this time directing his counsel at the players of the property bubble. In early 2004, he urged homeowners to shift from fixed to floating rate mortgages, and in early 2005, he extolled the virtues of sub-prime borrowing – the extension of credit to unworthy borrowers. Far from the heartless central banker that is supposed to “take the punchbowl away just when the party is getting good,” Alan Greenspan turned into an unabashed cheerleader for the excesses of an increasingly asset-dependent US economy. I fear history will not judge the Maestro’s legacy kindly. And now he’s reinventing himself as a forecaster. Figure that!

Greenspan or not, downside risks are building in the US economy. The sub-prime carnage is getting all the headlines these days, but in the end, I suspect it will be only a footnote in yet another post-bubble shakeout. America got into this mess by first succumbing to the siren song of an equity bubble (see my 25 April 2005 dispatch, “Original Sin”). Fearful of a Japan-like outcome, the Federal Reserve was quick to ease aggressively in order to contain the downside. The excess liquidity that was then injected into the system after the bursting of the equity bubble set the markets up for a series of other bubbles – especially residential property, emerging markets, high-yield corporate credit, and mortgages. Meanwhile, the yen carry trade added high-octane fuel to the levered play in risky assets, and the income-based saving shortfall of America’s asset-dependent economy resulted in the mother of all current account deficits. No one in their right mind ever though this mess was sustainable – barring, of course, the fringe “new paradigmers” who always seem to show up at bubble time. It was just a question of when, and under what conditions, it would end.

Is the Great Unraveling finally at hand? It’s hard to tell. As bubble begets bubble, the asset-dependent character of the US economy has become more deeply entrenched. A similar self-reinforcing mechanism is at work in driving a still US-centric global economy. Lacking in autonomous support from private consumption, the rest of the world would be lost without the asset-dependent American consumer. All this takes us to a rather disturbing bi-modal endgame – the bursting of the proverbial Big Bubble that brings the whole house of cards down or the inflation of yet another bubble to buy more time.

The exit strategy is painfully simple: Ultimately, it is up to Ben Bernanke – and whether he has both the wisdom and the courage to break the daisy chain of the “Greenspan put.” If he doesn’t, I am convinced that this liquidity-driven era of excesses and imbalances will ultimately go down in history as the outgrowth of a huge failure for modern-day central banking. In the meantime, prepare for the downside – spillover risks are bound to intensify as yet another post-bubble shakeout unfolds.



The Looming Housing Bloodbath

Unwary borrowers snared in US housing "bloodbath"
Mon Mar 12, 2007 12:16 PM ET

By Emily Kaiser

CHICAGO, March 12 (Reuters) - Renae Gorney sees the human side of the slumping U.S. housing market, the people whose homes are part of the $1 trillion worth of unconventional mortgages that are about to get more expensive.

Gorney, director of loss mitigation at Freedom Foreclosure Prevention Services in Mesa, Arizona, receives more than 300 applications a month from people facing foreclosure, and has little faith in forecasters who say the worst of the housing market downturn is over.

"It's going to be a bloodbath this year," she said.

Many of her clients -- homeowners who come for help renegotiating mortgage terms or to work out deals to avoid foreclosure -- have adjustable-rate mortgages that initially carried lower interest rates but will soon spike up.

The Mortgage Bankers Association estimates that between $1 trillion and $1.5 trillion in adjustable-rate mortgages face an interest rate reset this year.

As the housing market cools and homeowners have trouble refinancing or selling, more people are falling behind on mortgage payments. The delinquency rate for all types of mortgages rose to 4.67 percent in the third quarter of 2006 from 4.39 percent in the prior three months, a gain of 6 percent, according to the Mortgage Bankers Association.

Foreclosures last year were up 42 percent from 2005 levels, and will likely rise another 20 percent to 25 percent this year, real estate information service RealtyTrac Inc. says.


A jittery Wall Street has focused on the subprime mortgage sector, which lends money to people with poor credit histories. One such mortgage company, New Century Financial Corp. , has said its lenders plan to halt the financing it may need to fund its operations, as bad loans keep piling up.

While subprime mortgages have spread credit more widely and helped more people buy their own homes, critics contend a hot real estate market encouraged lenders to get more aggressive and offer increasingly complicated terms that borrowers did not always fully understand.

Housing has always been an integral part of the U.S. economy, but it has taken on greater significance in recent years as many consumers took out home equity loans and ramped up their spending.

Some economists worry that as house prices fall and lenders tighten credit terms, consumers will curb spending and drag down the U.S. economy.

Christopher Cagan, director of research and analytics at First American CoreLogic, estimates that adjustable-rate mortgage resets will trigger some 1.1 million foreclosures over the next 5 or 6 years, wiping out $110 billion in equity.

That may sound like a lot, but Cagan does not believe the fallout will tank the $13 trillion U.S. economy or even the mortgage industry.

"It's less than we spend on alcoholic beverages," he said.

Bill Rayburn, chairman and chief executive of FNC Inc., which provides collateral data to banks, said lenders are increasingly eager for information to help them value homes for both loans and foreclosures.

"Our phones are ringing off the hook," he said.

Rayburn, whose firm takes data from home appraisers to help banks process information for some 400,000 loans a month, said bankers "are in bunker mentality" as the housing market slumps, and desperate for details such as whether they can quickly resell a foreclosed home.


Lack of information is a big part of the problem for borrowers, said Freedom Foreclosure Prevention's Gorney. She says "99.99 percent of people just sign, sign, sign" without fully understanding mortgage terms.

Some of her clients had borrowed 100 percent of the purchase price on homes that are now worth less than the mortgage. She has referred a few to attorneys general to investigate whether they fell victim to fraudulent lenders.

"They've been sold the American dream and now there is no way to go forward," she said.

She talks of clients who signed blank loan documents and later discovered that they had agreed to interest rates as high as 10 percent. Others learned of high rates when it was too late to do much about it -- their belongings were on a moving truck in the parking lot while they signed the documents to close on a new house.

Malachi Cade, one of Gorney's clients in Monroe, Louisiana, said he didn't realize that he was late on his mortgage payment until the bank mailed back his check. When he called to find out why, they told him he was four or five months behind and they had started foreclosure procedures.

He's still not exactly sure what happened.

As the number of homeowners in financial distress soars, Gorney said banks are increasingly willing to consider alternatives that may be cheaper and faster than foreclosure.

Some troubled homeowners are turning over deeds in exchange for banks ripping up mortgages, a practice called "deed in lieu" of foreclosure. It damages credit ratings, but not as severely as a foreclosure would.

Even with those tools available, Gorney rejects nearly half of the applications she receives from homeowners looking for a way to avoid foreclosure because there is simply nothing she can do to help them.

Despite such problems, Rick Sharga at RealtyTrac said subprime mortgages aren't bad. It was more a matter of bad timing.

"We wouldn't be having this discussion if the real estate market was still booming," he said.

© Reuters 2007.

This page is powered by Blogger. Isn't yours?