The release of this 2008 1st Quarter newsletter is actually emerging into the 2nd Quarter. Without waiting to see how the Fed played out its hand – well, it would have been imprudent to attempt broader comment. As of now (beginning of April), the path has been chosen and we are once again in familiar territory. I have the occasion to glance over countless publications on a daily basis. It astounds me how prognostications of imminent ‘doom and gloom’ can dominate the same pages year after year, decade after decade, while the cliff never seems to draw any closer. This time around, you might say we actually came close.
The market for U.S. mortgages is represented in large part by the ability of mortgage brokers to sell fresh mortgages into the so called secondary market. That market is represented by players such as FNMA, FHA and Institutions like insurance companies and pension funds. The brokers bundle a bunch of mortgages and sell them to aggregators, like Bear Stearns, who package them and create contracts that are based upon these mortgage bundles. These so called derivatives get their value from components of the bundle. One party may want the fixed interest features of a 30 year mortgage, another may want the protection of variable rates. A contract is written to solve every problem and some cost is added at every step along the way. The brokers should not have a lot of risk if the borrower defaults. However, a typical $500,000 mortgage in default, bears the costs of foreclosure and has to be taken as a loss against the face value of the debt. Somebody has to lose money.
Moreover, if the underlying property has declined in market value to $400,000 – the costs of the foreclosure, the difference between the recovered amount, and the face value of the debt combine to result in a substantial loss. As clear as this is, these losses are within some realm of expectation and manageability, even in the aggregate. As all of these loans don’t originate from equally capitalized institutions, a turn in real estate sentiment might wipe out some smaller regional lenders – but we would expect century old institutions to be well-funded enough to take the loss simply as that – a loss. How quickly the story changes at 33:1 leverage (the rough level of leverage employed by the recently departed Bear Stearns). When that $500,000 debt instrument is itself placed as collateral on a $16,000,000 loan – and this operation is repeated over and over again until an entire financial empire is built floating on continued access to easy credit – the devaluation of some of that underlying collateral can lead to some pretty astounding margin calls.
In the case of the mortgage – unwinding the bet is a rather straightforward (though lengthy) procedure. However, when the bulk of that $16,000,000 dollars is put into exotic over-the-counter derivatives with almost no real trading market to speak of – if the scarce few buyers and counterparties cease to make a market – the write-downs can be deadly. While that brief narrative traces the creation of credit from the tangibly-backed and everyday mortgage into a web of increasingly complex and intangible products – the fears over the last month have been exactly the reverse; that as the spigot closes in more obscure markets, credit would seize up back down the credit chain until your local commercial bank found itself unable to offer the day-to-day staple loans that drive both commerce and our productive economic activity.
The Federal Reserve and the Treasury Department have taken three distinctive actions to keep this seizing from occurring:
March 14: the Federal Reserve’s discount window – previously available exclusively to commercial banks under regulatory controls – was opened to investment banks.
March 19: the Capital Reserve requirements of Freddie Mac and Fannie Mae were reduced.
March 24: the Federal Housing Finance Board doubled the number of mortgages that the Federal Home Loan Banks could buy.
The first of these actions has the effect of allowing debt instruments that have suddenly become impossible to market, to be laundered through the Federal Reserve itself in exchange for U.S. Treasuries. This new ‘clean’ money, along with the credit newly created under the second two policy changes, is currently hurtling into the system.
While the Federal Reserve no longer publishes the broadest measure of money supply (the M3), we here at The World of Money have been bringing you a recreation based on a series of figures still released. If you happen to have a copy or two of our recent newsletters handy, check the figures. The current rate of increase in the money supply is rapidly approaching 20% per annum. In other words, the system will be saved, at any cost. What the pundits often fail to explain is why they believe “the boyz” might be expected to one day get up and simply walk away from the gig. It has always been my opinion, and now the prevailing wisdom, that the game will continue at any cost. While the money supply increases at 20% a year, the bureaucrats declare that inflation is at the level of 4%. In a year or two – when gas passes $6 a gallon, oil goes above $150 a barrel, and gold is breaking down the door of $1600 – consider whether that 4% figure or that 20% figure made more sense.
While that may sound quite negative in its own right—there is time yet to prepare for the weight of the already undertaken inflation to percolate through the system and onto the shelves. In a more positive light, two congregating events are at least providing optimism for some sectors. As a rising money supply devalues our individual dollars, American exports become more affordable (and in some cases almost cheap) for consumers in other countries. Meanwhile, political pressure on China has finally led to a slow but steady appreciation in the yuan. This combination of more expensive imports and greater demand for goods to export should bode well for our manufacturing sector – and that is certainly a spot of news they’ve been waiting a long while now to hear. While everyone points their finger at real estate and lays blame for any current malaise on the bubble formed there, I hope this article made it clear that it is the nature of highly leveraged investments – not some oscillation in home ney now available to foster new mortgages; in the context of a Federal Reserve that has shown itself committed to maintaining the current system for better or worse – it is hard to imagine real estate can be far from its bottom. All-in-all, the cliff remains exactly where it always was; right in front of us just a little down the road. It’s just that we aren’t heading anywhere fast.