Saturday, March 1, 2008

Debt Rattle, March 1 2008

I couldn't see the rising
'cause the dark was in my sky
I couldn't see the sun
'cause the sun was in my eye

Ilargi: I don’t know if you noticed, but I have, repeatedly, in the past few weeks. For some obscure reason, in the world of finance, feedback loops work in reverse. When it comes to money, the negative feedback loop is the self-reinforcing one. In physics, of course, that doesn’t pass even the simplest test. Perhaps economists are simply not terribly smart.

True impact of mark-to-market accounting in the credit crisis
Back in April 1993 the eyes of the world were on the beseiged Balkan town of Srebrenica, which the UN declared a safe haven for Bosnian muslims, and on Northern Ireland, where secret talks between leaders from rival factions kick-started a tentative peace process. In the same month, a less-noticed development saw US accountancy regulators approve a rule that paved the way for today's widespread use of mark-to-market accounting standards.

This rule, which forced US banks to carry more securities at market value, emerged from the wreckage of the US savings and loan crisis when losses on loans had been hidden by the use of "historic cost" accounting.

Only now, in the middle of a global credit crisis, is the impact of the broad introduction of mark-to-market accounting becoming clear. The critical concerns are around how much these changes helped to inflate the credit bubble and whether they will increase the speed and destructive power of its collapse.

To be fair, the US banks protested at the outset that the move would change their role in the economy. So did the French banking federation before similar changes came to Europe in 2005. It warned that fair-value accounting "could even further increase the euphoria in a financial bubble or the panic in the markets in a time of crisis". Tobias Adrian, an economist at the New York Fed, and Hyun Song Shin of Princeton University, have produced a string of work about this kind of "pro-cyclicality" in finance and the economy, culminating in a paper last September entitled Liquidity and Leverage .

This paper examines the links between asset prices and the value of banks' capital bases when mark-to-market accounting is used. It postulates that banks are driven to lend more and grow their balance sheets as the value of their capital rises. This is because they target a more or less constant leverage multiple on their balance sheets.

The paper concludes it was inevitable that an industry buoyed by rising asset prices would pursue increasingly aggressive lending growth. This pushed credit upon ever more risky clients and loan structures, which then fed into asset price growth. This of course added more fuel to the fire - or created "positive feedback loops".

The most disturbing conclusion is that this system should behave in exactly the same way in reverse, creating "negative feedback loops" with a destructive impact on all kinds of asset values - from structured finance to house prices and equities.
In a way this is nothing new - the old adage about a banker is that he gives you an umbrella when it is sunny and asks for it back when it starts to rain.

But there are two important differences. First, fair-value accounting will speed up the process. One of Adrian and Hyun's conclusions is that it was the speed of balance sheet expansion that caused the most blatant excesses of US mortgage lending. Second - this isn't mentioned in the paper - there is the impact of securitisation, the practice of converting illiquid individual loans into saleable securities.

Subprime Crisis Takes Huge Toll on Economy
Subprime mortgage delinquencies and the credit crunch will trigger $400 billion in losses to the U.S. financial system and knock 1.3 percentage points from growth in 2008, according to a paper released Friday by four leading economists.

"While these estimates have many caveats, they still suggest that the feedback from the financial market turmoil to the real economy could be substantial," a quartet of academic and Wall Street economists wrote in a paper to be presented at a monetary policy forum organized by the business schools of the University of Chicago and Brandeis University.

The economists said half of the $400 billion in losses will be borne by leveraged U.S. financial institutions, many of which took risky bets on subprime mortgage securities that turned sour when delinquencies rose.

The paper's authors -- David Greenlaw of Morgan Stanley, Jan Hatzius of Goldman Sachs, Anil Kashyap of the University of Chicago, and Hyun Song Shin of Princeton University -- said that as hard-hit financial institutions shore up their capital, they will retreat from extending credit to the tune of about $910 billion. A drying up of credit availability will cause businesses and consumers to pull back from spending and investing, the authors say.

Panelists and participants in the forum include Fed Governor Frederic Mishkin, Boston Fed President Eric Rosengren, Chicago Fed President Charles Evans, St. Louis Fed President William Poole, and Bank of England Executive Director Paul Tucker. The paper comes shortly after the Fed itself presented a gloomy outlook for the economy in months to come as it struggles with a deep housing slump, tighter credit and financial market turbulence.

Fed Chairman Ben Bernanke, whose own academic work includes extensive study of how financial market malfunction hurts the broader economy, told Congress this week he expects sluggish growth in coming quarters. The economy expanded at a meager 0.6 percent in the final months of 2007, and some analysts forecast recession this year. The Fed's forecast is for growth between 1.3 percent and 2 percent, and Bernanke has said the Fed is not forecasting recession.

Meanwhile, the economists said in their paper on Friday that stress to financial markets in recent months has surpassed anything in the past 18 years, including the failure of the Long Term Capital Management fund and the 1990-91 U.S. savings and loan crisis, citing elevated risk premiums being charged in money markets.

Adding to the dour projection, the economists said that housing markets will be harder pressed to recover in the current episode than after past housing busts. This is because credit standards were more lax during the most recent boom, and because so many adjustable rate mortgages are due to reset at higher levels.

Ilargi: And believe it or not, there are people who insist this is a positive development.

Canadian home prices almost double in record decade
The past decade has been one of the best on record for housing in Canada, pointing to a 7.1% annual compounded return from 1997 to 2007, Re/Max said on Thursday. The real estate company said between 1997 and 2007, average home prices in Canada almost doubled, to $307,265 in 2007 from $154,606 in 1997. Re/Max also says sales have climbed from 331,092 in 1997 to more than half a million last year.

Edmonton won top spot for greatest price appreciation, in the survey. The average sale price in the Alberta capital went from $111,587 in 1997 to $338,636 last year. Prince Edward Island led the country in improved sales, with the number of homes up 119% from where it was a decade ago.

"Never before have we seen such a continuous run-up in Canadian real estate. Clearly, strength in all markets has been directly linked to solid growth in local, provincial and national economies. Low interest rates, job security, and consumer confidence have all served to further bolster home-buying activity across the nation," says Michael Polzler, executive vice-pesident of RE/MAX Ontario-Atlantic Canada.

Re/Max surveyed 19 markets and found 12 had price increases of 40% to 60% over the past decade. The company said western Canadian markets generally outperformed the rest of the country. "Immigration and in-migration have played a serious role in jumpstarting residential housing markets, particularly in British Columbia, Alberta, and to some extent, Saskatchewan over the past decade," says Elton Ash, executive regional vice-president of RE/MAX of Western Canada.

Ilargi: How to recognize a moron: "Our losses related to the U.S. residential mortgage market are a significant disappointment and are not aligned with our strategic imperative of consistent and sustainable performance,"

CIBC warns more losses could come
Q1 Loss of $1.46-billion following $3.38B in write-downs

Canadian Imperial Bank of Commerce posted a big first-quarter loss on Thursday due to charges of $3.38-billion before tax on U.S. mortgage-related securities and credit protection. The charges are up from the US$2.5-billion figure the bank had already warned of in January.

It noted that market and economic conditions relating to U.S. bond insurers could change, and it said this could result in "significant future losses." CIBC, which has been damaged by the U.S. mortgage crisis more than any other Canadian bank, said it lost $1.46-billion, or $4.39 per share, in the three months ended Jan. 31. That compared with a profit of $770-million, or $2.11 a share, a year earlier.

"Our losses related to the U.S. residential mortgage market are a significant disappointment and are not aligned with our strategic imperative of consistent and sustainable performance," Gerry McCaughey, CIBC's president and chief executive, said in a statement. The bank replaced several senior executives in January, and issued 45.3 million new shares worth $2.9-billion to shore up its balance sheet in the wake of its structured-credit problems.

One analyst said he doubts very much that those problems are over. Brad Smith, an analyst at Blackmont Capital in Toronto, said he expects "potentially severe additional loss developments" in the next 12 months because it appears that CIBC hedged its bets with some of the weaker U.S. bond insurers.

"I think you'd have to have a very optimistic view of the outlook for U.S. economic developments" to conclude that CIBC's woes are behind it, Mr. Smith said. "If a U.S. recession were completely avoided and the distressed housing market got some support, then this quarter's charges could represent the bulk of CIBC's losses," he said. "But our view is that neither of those conditions are going to be the case."

The bank's quarterly results were hurt by a slew of pretax charges including $2.28-billion on credit protection purchased from U.S. bond insurer ACA Financial Guaranty Corp, $626-million for credit protection bought from other financial guarantors, and $473-million in mark-to-market losses on securities tied to the U.S. residential mortgage market.

Ilargi: First, you call yourself an energy super power, and then you run a record budget deficit. So what mask do you put on? Simply top it off by claiming you run a bleeping deficit BECAUSE you are so bleeping strong. The Canadian public is far too morose and self-obsessed to notice they are being fed stupidity. It takes one to know one, that sort of thing. I fear for Canada, I fear for it a lot.

Current account heading toward record deficit
Merrill Lynch forecasts $36B shortfall in 2009

Canada is heading for a record current account deficit of $36-billion in 2009, a lightning speed transformation from a decade of surpluses as the economy realigns itself toward imports from exports. Merrill Lynch forecasts the switch will occur this year as Canada moves to a $20-billion deficit from a surplus of $12-billion in 2007. The deficit will continue to swell in 2009.

Although the change will ultimately put pressure on the Canadian dollar, it is very much a function of the loonie's recent strength--and a strong domestic economy -- which will continue to fuel imports. Flattening commodity prices and less dramatic gains from income abroad will also be major drivers said David Wolf, Canadian economist at Merrill. "Canadian demand is a lot more relative to the world than it was five years ago," Mr. Wolf said. "Canadians are richer and they are buying more goods and services from abroad."

The switch may be abrupt for a country used to crowing about its triple surpluses -- fiscal, trade and current account -- but will be a reflection of strength, Mr. Wolf said. The current account numbers are the broadest measure of a country's international trade, including goods, services, investment gains, travel and pretty much everything else. A big deficit would mean Canadians are consuming far more of the world's wares than they are exporting and would put Canada in a position that the United States has been criticized for over for years.

Still, a $36-billion deficit would be a record in nominal terms but at 2.2% of GDP it will still be below the 4.8% recorded in 1975, the year of Canada's largest prior deficit. It will also be lower than the United States' deficit, which is forecast at 3.9% in 2009, and well below its peak of 6.2% in 2006. More important will be the source of the deficit. The current account deficit days of the early 1990s were driven by large government borrowings abroad. This time it will be a reflection of strong domestic demand and higher relative rates of return at home.


Anonymous said...

Negative feedback loops cancel by definition and positive feedback loops go out of control and oscillate. The world of mark to market finance tends toward positive feedback loops and this causes violent oscillations.

Asset bubbles create positive feedback effects. And, yes, it works exactly like it does in engineering and physics. I suggest that people who don't know the difference between positive and negative feedback loops shouldn't be lecturing on them.

There's an old saying - probably older than you - that if you design an amplfier you'll get an oscillator and if you design an oscillator you'll get an amplifier.

The old saw about the job of a central banker being to take away the punch bowl when the party gets good is an example of how the central bank should operate as an agent of negative feedback.

The lesson that will never be learned is that a fiat based financial system that optimizes for profits will never be stable. Not when credit can be issued and borrowed at low cost using the rising mark to market values as collateral.

You're right about economists, though. Dumb fuckers, all. Krugman included. But what do you expect from bunch of turds who sit around counting on their fingers all day?

madhatter said...

Question: How "big" are the losses that are being incurred by CIBC and BMO? Are they speed bumps, hurdles, or brick walls? The link that you posted on CIBC mentions $3.38B - the accompanying article on the Financial Post talks about exposure on non-subprime being between $20B and $25B. Investors Can Only Guess If the rating agencies actually come out and say the the monoline emperors have no clothes, does it only mean drop in share price, or might it lead to something a little more hazardous?

Mish's site has a few BMO related articles on his site today. What does a comment like, "We are struggling to hang on." actually mean? Bank Of Montreal May Abandon Debt Rescue

Greyzone said...

"As I have emphasized before, the Federal Reserve can deal with liquidity pressures but cannot deal with solvency issues." - William Poole, President, Federal Reserve Bank of St. Louis.

Those who argue that we are facing an inflationary problem need to read that sentence several times until it sinks in. The current problem is solvency. On top of that is the problem of trust. No amount of inflated dollars can resolve solvency issues or restore trust in the financial institutions.

Cid Yama said...

I grew up in Algonac, Michigan. Just across the river. We had Canadian TV, Canadian Radio, Canadian pipe and drums in our parades. We went to Canadian beaches, Stratford for Shakespeare, My younger sisters to Canadian bars when they raised the drinking age back to 21 in the States. We spent half our life in Canada. Canada was ALWAYS friendlier, cleaner, more polite, more educated, and more refined than the States. To hear from you that Canada has degenerated to mear lackeys to TPTB in the US pains me enormously. Canada to me was the hope for a better world, a refuge from the vulgarity of the States.

Leon said...

Take a bit of the smoke they are blowing up our asses, add a mirror here and there, and voila!, every little thing gonna be all right. Just don't pay no mind to that man behind the curtain.

pihwht said...

"the typical term for this sort of margin call is 72 hours"

Can't see how a bank will get any cash from a homeowner within seventy-two hours. I can see the loan being called, but can't see how do so would help answering the margin call.

pihwht said...

"the typical term for this sort of margin call is 72 hours"

Can't see how a bank will get any cash from a homeowner within seventy-two hours. I can see the loan being called, but can't see how do so would help answering the margin call.

Alan said...

Hi Ilargi, Thanks for all your hard work on this blog/nightmare.

Hyperinflation or deflation comes up a lot. How can we know which to expect? It really comes down to government spending and tax revenues rather than money supply increases. Two of the great instances of hyperflation are Germany in 1930's and Zimbabwe today.

In Germany tax revenues were about 1/4 expenditure. In Zimbabwe the productive base has been destroyed so the 'government' prints money like crazy and spends it.

We won't get hyperinflation if the government gives any amount of money to the banks. The money needs to be spent which it wouldn't be if it just fills holes in the banks' balance sheets.

To get hyperinflation in the US the budget deficit needs to explode - which it might.

Either way there is a big transfer of wealth away from the US happening now.

HilObama McCain ,wants to be president. Proof they are nuts.