So equity markets have taken the view that goldilocks is alive and well. The US economy has been saved by the Federal Reserve’s timely intervention back in September and at the same time inflation is under control (despite the fact that Turkish troops massing on the Iraqi border have contributed to another surge in the oil price).
Well, at the margin the backdrop is about as normal as walking in on your dad doing the ironing in your mum’s skimpy negligee! We read, this week, about the possible creation of a so-called “super-fund” being set up by Citigroup, JP Morgan and Bank of America with an estimated $75bn – $100bn of liquidity back-up (the fund, for acronym fans, is to be known as an M-LEC or Master Liquidity Enhancement Conduit according to the FT or “Super-SIV Fund” elsewhere, where SIV = Structured Investment Vehicles, off-balance sheet operating companies set up by banks and others to fund investment in assetbacked bonds of varying and variable quality).
The suggestion was apparently born from a meeting between senior Wall St. bankers and US Treasury officials in response to ongoing indications of distress in the markets for mortgagebacked and commercial paper markets. The scheme’s supporters are quick to deny any suggestion that the fund is to act as a bail-out, but the further one digs the more it looks like it might be.
Three weeks ago US Treasury Secretary and Goldman Sachs old boy Mr Hank Paulson met with senior US bankers with the view of exploring the possibility of setting up a fund to soak up the asset-backed commercial paper showing every sign of creeping its way back onto bank balance sheets. The first and most obvious point is that if a fund of this size is rumoured to be in the making then surely significant liquidity problems continue to beset certain areas of the mortgage and commercial paper markets?
…and indeed they do. According to a recent investigation into the state of health of SIV market by Moody’s, assets held by these bank-created vehicles have fallen sharply, from $395bn in July to $320bn now. Great! Well, actually not so great! What has been happening is that the banks have been forced to repatriate commercial paper back onto their balance sheets and as a consequence are being suffocated by assets they never planned on holding directly, thus tying up regulatory capital and raising the possibility of impaired credit extension. Sure enough, the Fed’s own data does indeed show that the largest US commercial banks saw $280bn of new assets come onto their balance sheets in the period following the first week of August whilst over the same time period net assets fell by $40bn.
Will the lending environment turn negative?
This has never happened before, ever! And in such a short time! The short time scale is significant because it indicates a steep and dramatic compression in the banks’ capital which in turn raises the real prospect of a severely negative lending environment. In turn again, this raises the very real prospect, if unchecked, of a serious threat to economic output growth in an economy that has become more addicted to debt than at any stage in history.
But we’re in luck! Mr Paulson has considerable experience at a senior level on Wall St. and whilst he may not have seen anything as ugly as this since Charles Laughton swung from the bell towers of Notre Dame he has sufficient wherewithal to know the dangers associated with “dropping a clanger” here. The point is that bringing these off-balance sheet vehicles back on balance sheet raises the very real prospect that the credit creation process might be cut off in an instant, particularly so since 30% of the growth in debt taken on by US households was backed by such vehicles in the first place. It has been estimated that in order to get bank capital / asset ratios back to where they were in July would, without the support of external involvement, require an additional $60bn of bank equity!
So what about the fund itself?
Could the super-fund save the structured credit market?
From an economist’s perspective the fund would, if it receives sufficient support, represent a partial solution to the age-old problem that asymmetrical information between buyers and sellers poses. A more down to earth example might be the parallel with the second hand car market which won Mr George Akerlof a share of the Nobel Prize for economics in 2001. In his work Mr Akerlof found that most buyers had no way of discovering whether the second hand car they were buying was faulty and would therefore demand a discount to compensate for buying a faulty vehicle.
However, at the new price potential sellers of good quality second hand cars might consider the price too low and refuse to sell the car. The resultant buyers and sellers’ strike is created by asymmetrical information the potential consequence of which is that the overall market shrinks leaving an illiquid rump of stock at the end.
This is exactly what has happened in the market for structured credit as buyers are unable to tell which structured products are riddled with the woodworm of sub-prime mortgage debt. Akerlof’s thesis is being applied exactly to the real world. Buyers are now demanding significant discounts which the investment houses are unwilling to accept as it would depress the values of their own portfolios, reducing capital reserves (as identified above), forcing curtailment of borrowing and resulting in a dangerous negative spiral of debt deflation (see Week in Previews passim).
Citibank, the largest perceived purveyor of SIV’s and other off balance sheet conduits, is attempting to clear up the mess partially of its own making by creating a “super conduit” to invest in, crucially, triple and double AA mortgage related tranches. In effect this fund is underwriting the values of good quality second hand cars. There are two significant problems as we see it. Firstly and most obviously, the US housing market is continuing to deteriorate (see below). This means that some tranches currently rated at double or triple A may well be cut as the crisis in the real economy rumbles on and delinquency and foreclosure increases. Secondly, the Citibank proposal would inevitably condemn more lowly rated sub-prime mortgages and other tranches to the dustbin for which there would be no market unless the US government stepped in and provided its own bailout.
In conclusion it is hard to escape the feeling that what is being proposed is a gigantic curate’s egg: good in parts but bad and risky in others. The fact that the US Treasury and the larger investment banks recognise the challenge is also a good thing and if successful, should go a further step towards resolving near-term liquidity issues. It also serves, however, as a reminder that serious problems persist and whilst reigniting the credit cycle for high quality paper it does little to resolve the ongoing crisis in the US residential property market.
The US housing crisis could be as bad as the 1930’s!
The reason for this doom-laden headline is that the combination of higher mortgage rates and lower house prices pushed foreclosure rates up by 99% year on year in September, to 233,538! This is not a small number! Countrywide has already announced that its delinquency rate has soared from 4.04% one year ago to a current 5.85% and new loans have fallen by 44% over the same period. According to RealtyTrac 500,000 mortgages are resetting in November, thus the foreclosure rate is sure to climb further still, with an equally alarming increase in the inventory of unsold homes.
Note too, that six of the ten states with the highest levels of foreclosures are regarded as vulnerable by the Republican Party (according to the Wall St. Journal) ahead of the November 2008 Presidential Elections and Hilary Clinton now has a massive lead over her Democratic rivals in the latest opinion polls. In terms of consumer confidence, what was thought to be (and still is thought to be amongst some commentators) a containable crisis is showing signs of spreading. Although employment growth remains positive it is now half the level of a year ago and is trending at a mere 1% annualised. Adding to the negative outlook for discretionary spending the oil price has surged in the futures pits which, if sustained, could drain c1% point from households’ available income year on year. Judging by recent retail sales statistics the US consumer appears in robust health, however, much of this can be put down to aggressive spending on credit cards.
Whilst this may continue for a few more months it is highly debatable as to whether it can continue in perpetuity, especially as house prices in the round are deflating at their fastest rate since 1991. Whilst the University of Michigan confidence data indicates that the nation’s innate optimism is intact, the latest survey (82 against 83.4 in September and its lowest level since August 2006) does show that cracks are beginning to appear. We are surprised by developed equity markets’ continuing strength in the light of the above, particularly in the light of the sub-index “expectations” element falling from 74.1 in September to just 71.6 at the preliminary reading for October. Perhaps the answer might lie in the continuing hope that Fed Chairman Ben Bernanke and his Open Markets Committee coterie may cut base rates again at its end-October meeting. The concern, widespread amongst many economists, is that it may not make much difference.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley