Krishna Guha and Gillian Tett are a pretty reliable team. When they say something, they can be trusted farther than any other reporter can. Furthermore, Tett (probably Guha as well) has sufficient market savvy so as not to be BS’ed into an explanation that suits Wall Street.
Nonetheless, their latest article leaves something to be desired.
When Ray McDaniel, president of Moody’s, addressed a debate in Davos last week, the mood was so hostile that some speakers joked that he was brave to appear “without a bodyguard”.
No wonder. As the credit squeeze persists, ratings agencies are being forced to downgrade thousands of securities, after failing to foresee the recent wave of defaults, particularly in subprime loans. On Wednesday night alone, Standard & Poor’s downgraded more than 8,000 residential mortgage-related securities worth some $534bn (£268bn, €360bn).
These downgrades have triggered bitter recriminations, amid a wave of losses at asset managers and banks. “Much of the money lost has been held by people who held AAA securities [that were downgraded],” points out Wes Edens, head of Fortress Investment Group, a big hedge fund. “That has caused a tremendous loss of confidence.”
But the downgrades have also left policymakers and analysts scrambling to determine what has gone so badly wrong. As this search intensifies, some economists are starting to suspect that the answer lies in a striking recent change in American household choices – a shift that could have important implications for policymakers and investors alike.
In particular, it seems that mathematical models used to predict future default rates, based on past patterns of losses, have gone wrong because they did not adjust to reflect shifts in household behaviour. Or, to put it another way, financiers have been tripped up because they ignored one of the most basic rules of investment, which is usually found in product literature: the past is not always a guide to the future.
“There has been a failure in some of the key assumptions which supported our analysis and modelling,” Mr McDaniel admits. “The information quality deteriorated in a way that was not appreciated by Moody’s or others.” Mortgage borrowers, in other words, did not behave as expected.
The issue at stake revolves around so-called delinquency rates, the proportion of people who fall behind on their debt repayments. When American households have faced hard times in previous decades, they tended to default on unsecured loans such as credit cards and car loans first – and stopped paying their mortgage only as a last resort. However, in the last couple of years households have become delinquent on their mortgages much faster than trends in the wider economy might suggest. That is particularly true of the less creditworthy subprime borrowers. Moreover, consumers have stopped paying mortgages before they halt payments on their credit cards or automotive loans – turning the traditional delinquency pattern on its head. As a result, mortgage lenders have started to face losses at a much earlier stage than in the past.
“In the past, if a household in America experienced financial problems it tended to go delinquent on its credit cards, but kept on paying its mortgage,” says Malcolm Knight, head of the Bank for International Settlements, the central banks’ bank. “Now what seems to be happening is that people who have outstanding mortgages that are greater than the value of their home, or have negative amortisation mortgages, keep paying off their credit card balances but hand in the keys to their house … these reactions to financial stress are not taken into account in the credit scoring models that are used to value residential mortgage-backed securities.”
One possible explanation is that it has become culturally more acceptable this decade for people to abandon houses or stop paying in the hope of renegotiating their home loans. The shame that used to be associated with losing a house may, in other words, be ebbing away – particularly among homeowners who took out subprime loans in recent years, as underwriting standards were loosened. Consumers may also be rationally re-evaluating the costs that come with defaulting on different forms of debt, in the light of recent bankruptcy law reforms in America.
But there is a more fundamental economic explanation. In the past, it has usually been assumed that mortgage defaults occurred due to cash flow problems: if a borrower lost a job, for example, he or she would no longer have enough income to service a housing loan. However, if households were actually running out of cash, they might have been expected to stop paying credit card debt too, to a greater degree – implying a change is afoot.
Previously in America, the property market has softened during times of recession and rising unemployment. But this time, house prices have fallen even though unemployment has not risen. Mortgage delinquencies started to surge two years ago, or as soon as house prices stopped rising and then started to fall. That might be because overstretched households with unsuitable loans were no longer able to refinance their way out of trouble, when house prices stopped rising.
1) The government has been warping statistics beyond repair since 1995. Unemployment has been rising. 3 percent of the population of California has real estate licenses. How many of those people do you think are actually selling real estate? Aggregate hours worked has been falling. That means the same number of people are working fewer hours, or a smaller number of people are working the same hours. Same thing.
2) The ratings oligopoly was allowed to capture fees from the companies whose securities it was supposed to vet. The SEC has been turning down ratings-agency applications for the past decade to protect Moody’s, S&P, and Fitch. Knowing that no more competition would come allowed the Big Three ratings agencies to rake in more fees sloughing garbage securities off to investors.
Blaming the subprime fiasco on “improper modeling” is myopic. It is in the nature of any model to fail sooner or later. This was not about underestimating delinquency rates. It was about the ratings agencies’ regulatory capture of the SEC, which gave them the leeway to talk up their prima facie-absurd projections.
Of course, government is in the business of providing “solutions,” not taking responsibility. And the American people obviously have better things to do than care about what goes on in DC (like supplying the market for all those Britney paparazzi), so it’s not like they’re complaining about being fleeced.
Well, I think you are on mark w.r.t. Monlines:
Setback for monoline rescue.
http://www.ft.com/cms/s/0/3028204a-d291-11dc-86…
It appears that PE players aren’t interested.
Still, the delusion will probably continue.
A couple points.
Many home were bought as investment incomes, as opposed to prmary residences. These are the first to be given up.
Unemployment figures for the past decade are unreliable. They are usually based on the number of people receiving unemployment insurance or on welfare.
Sort of a hidden recession that has been accelerating among the working class, the vast move to outsourcing manufacturing has affected millions who worked in factories and related services.
People earning steady substantial incomes now are doing part-time jobs of anything from gardening, repairing electronics to delivering pizzas. But technically they’re still employed! Only their earnings are maybe half what they once were, with no inbuilt retirement benefits.
This tends to be regional, but has affected a subtantial portion of the workforce.
Mike Feldman
Shankar: Private equity firms can’t even place their own LBO debt. How are they supposed to finance a de facto distressed LBO when there’s $150-200 billion of constipation on Wall St.’s debt pipeline already?
Mike: Totally agree on all points. Furthermore their purchasing power has substantially eroded, and as China exports more price increases that effect will only accelerate. Unions will gain enormous legitimacy as well as political power over the next decade as a result of workers’ nebulous conviction that they have been screwed. (It’s a correct conviction, imnsho.)
Sadly, it’s also another reason to take capital anywhere but the United States.
Haha, Shankar and bonds7, I’m sure you enjoyed this quote from the FT article:
“The financial guarantors pass neither the shadow test nor the ability-to-understand test.”
Blackstone put a decent chunk of change in FGIC, and WP blew a billion on Ambac. The PE people are very short of cash and they aren’t going to be so readily burned again.
Now I guess it’s up to Citigroup to borrow another $20 billion from the government via posting of trash collateral.
I am absolutely confident that America’s financial institutions will muster whatever myopia is necessary to, in the immortal words of Chuck Prince “keep on dancing”.
has anyone seen the really scary fed charts?
do a google blog search for “scary fed charts”
these should help.
we are heading toward deflation or hyperinflation.
Iran is decoupling oil from dollars, saudi arabia is unpegging interest rates from ours which is causing fear they may follow iran. kuwait has already unpegged their interest rates to fight inflation. china will probably want to diversify in euros as well. the dollar is going to collapse. i am just worried it may lead to the Amero.
aaron,
Saudi Arabia hasn’t done anything yet. If China diversified out of dollars immediately they would be a much bigger loser than we would.
The end is not nigh.
China, like Saudi Arabia and it’s smaller oil-rich neighbours, has found itself in the uncomfortable position of becoming dependent on the steady influx of US dollars.
The sentiment growing is to screw the Americans, but the question arises, will they be shooting themselves in the foot – cripplingly. They would gain some domestic popularity and international leverage, but would they be killing the golden goose, at the same time?
My feeling is they are coming closer to the conclusion that with the payback diminishing, it’s worth abandoning the US and seeing what happens.
A substantial amount is riding on the anticipation of a new American administration, that could be more sympathetic and less adversarial than the one in place. Perception counts for a lot, even with cold economics.
The US is not currently playing it’s cards right. Something has to give.
Mike Feldman
Mike,
If China dumps dollars, it smashes the dollar down, and it pays an unacceptable embedded cost. It’s not like China sells all its dollars at 7.2 yuan/dollar and the US-Chinese exchange rate then plunges to, say, 2 yuan/dollar. It sells some at 7.2y/d, some at 7.199, some at … 2.001. A dollar dump is not in China’s interest because they lose a huge amount of money.
Additionally, Bush’s Washington has a very good relationship with Beijing. Both countries do a lot of pandering to their domestic audiences, but the gulf between the US and Chinese cultures is such that that’s how the game has to be played. The Chinese, like the Kremlin, much prefer the Republicans (at least in their current form) to the Democrats.
The Republicans are pretty reliably pro-free trade. The Democrats aren’t.
I don’t question your conclusions, they’re much better informed than I could hope to offer.
I do wonder how completely the Chinese and others are locked into the dollar. Is there a longer term upside for them bailing, in the near future?
As to Democrats and Republicans having different policies – the 2 countries I know best, Britain and Canada, have seen a blurring of parties. They don’t necessarily follow the same traditions as their predecessors.
Circumstances and world markets are very different from in previous times.
Mike Feldman
People say we’ll see either deflation or high-inflation.
I think there is a possibility we’ll see both – just not at the same time.
The speed of rate reduction increases the possibility that we’ll see an inflationary recession first (commodities inflation with a recession) and as the economies around the world slow down dampening demand, we’ll then see a deflationary recession.
My guess is that our Chairman is flying those helicopters to avoid the deflation (or deflationary recession), but he probably will find (as the then Fed found out by 1931) that he can only delay it.
If this indeed happens, I think he should be honest enough to return his Ph.D. back to his University and become Mr. Bernanke again. Wouldn’t it be sad to become an expert on a subject (The Great Depression) based on a certain hypothesis only to realize (after 30 years) that it was all wrong and waste of time?
But hey, I could be putting my foot in the mouth. Perhaps we won’t see deflation.
As far as the PE industry goes – Last summer I kept asking the question how long the PE boom will go. And each time, I was assured that it will last at least for another 1-2 years, and how the PE creates an underlying bid for the market etc. So much for the smart minds in PE industry.
(Disclosure: Lots of friends in PE industry.)
It surely is a sad state of affairs when the canadian dollar is worth more than the american dollar.