Back to the Future in the Credit Derivative Time Machine

It's hard to believe that it was just a little more than a year ago when the word "subprime" first became a cause for general investor concern and we were told by analysts not to worry. January 31, 2007 figures showed that GDP was growing at 4.4% and even though residential fixed investment had plummeted 19.2%, Global Insight chief economist Nariman Behravesh confidently claimed in the Wall Street Journal that "the soft landing is over, and I'm not even sure there was a landing."

Richard Moody of Mission Residential was even more confident. "For all of our worries about the housing market acting as a drag on consumer spending, there was no evidence of this during the fourth quarter," he said in the article.

But subprime problems were getting increasing attention in the media. Unfazed however, the National Association of Realtors reported that February 2007 existing home sales were "amazingly robust" having risen 3.9% to 6.69 million homes annually. In April, the NAR said it expected home sales to fall 2.2% in 2007 versus 2006. As it turns out, they dropped 22%, or 10 times the NAR estimate on a year-over-year basis to December 2007 but that is another story.

But at the time, there was at least one lone voice in the wilderness crying wolf. Jim Grant of Grant's Interest Rate Observer brought the true seriousness of the situation to the financial world's attention in a March 2007 Bloomberg interview. Here are a few snippets about that fascinating interview as discussed in our March 9, 2007 TradeSystemGuru.com weekly newsletter.

According to Grant, the troubled part of the mortgage market is immense, far larger than most analysts are letting on or at least that was the insinuation. The problem as he saw it was that "hundreds of billions of dollars of these 'science projects' of collateralized debt obligations and the like are sold in any year – immense amounts. What are they? You take a bunch of loans and then you fashion an asset backed security then take those loans and repackage them into a collateralized debt obligation or CDO. There can be a million individual loans in a CDO," he explained.

"Now here is the magic and mystery of a CDO," Grant continued. "You can take 70% of a pile of triple-B minus (meaning marginal credit) and the rating agencies will bless it. They will say that 'we have studied the correlations and trends and we pronounce 70% of this pile of junk to be triple-A,' triple-A!" he exclaimed (emphasis is his not mine).

What did Grant forecast at the time? "I think that the credit cycle will proceed, that risk will be re-priced and be recognized where it has not been recognized, debt will be more expensive and people will be hurt because they can't refinance (at least 20% of the loans written in the last two years would not qualify today under new lending guidelines) and the housing situation will be visibly worse." He wasn't just whistling Dixie.

Now contrast Grant's outlook with comments from another analyst who was interviewed earlier in the week of March 9, 2007 who stated that the sub-prime situation currently only affected 10% of 7% of the market or just 0.7% of the borrowers. Meanwhile Grant's estimate that 40% the mortgages issued in 2006 were either sub-prime or Alt-A mortgages (and therefore risky) proved far more accurate. Too bad more investors didn't take Grant's comments to heart.

The April 13, 2007 Wall Street Journal included a survey of economists in which 20 of 54 cited soft capital spending as the chief risk to their forecasts that the economy would continue growing and avoid recession in 2007. The group estimated a 26% chance for recession over the next 12 months. Housing market concerns were growing but were still considered relatively minor, especially outside the U.S.

In a May 17 speech in Chicago, relatively new Fed Chairman Ben Bernanke commented that the slowdown in the subprime mortgage market would put "some restraint" on home buying but said it shouldn't have much impact on the broader economy. At the time Bernanke still believed that U.S. home prices were rising because that is what year-over-year median home price data were saying at the time. "I think the market has already digested that housing news," Owen Fitzpatrick of Deutshe Bank was quoted as saying in the Wall Street Journal at the time. Those comments may seem miraculously myopic now but they reflected the common wisdom at the time.

Then in June, the first serious subprime cracks began to appear (as Grant had accurately predicted) when Bear Stearns reported a 33% drop in net income due to risky mortgages as one of its hedge funds was trying to unload $4 billion in mortgage-backed bonds. Goldman also posted a 1% decline in revenues due to subprime problems. Bank shares however, were barely affected. From June on however, the term "subprime" would become much more dominant in the financial news as financial share prices began to fall in earnest with each new piece of bad news. Meanwhile, NAR data still showed median existing home prices rising across the U.S.

In July, Standard & Poor's and Moody's threatened to downgrade ratings on residential mortgage-backed securities then Moody's cut its rating on 399 classes of mortgage securities. It came at a time when investors had been doing their level best to convince themselves that housing problems were limited and the worst was over. But the rating cuts served as an undeniable wake-up call. The term "subprime" was appearing multiple times in weekly stock market commentaries. Here is an interesting comment from the Wall Street Journal on July 11 by Joanna Ossinger.

"The subprime-mortgage issue has been a worry for stocks for months, but problem spots have been revealing themselves only sporadically. The market's late-February dive was based partly on concerns about subprime, but the issue stayed dormant for some time after that, resurfacing in force when two Bear Stearns hedge funds nearly blew up based on their subprime investments. Continued weakness in housing and an increase in mortgage defaults have kept those worries simmering. But in a world of increasingly complex financial derivatives and other instruments, it is basically impossible to determine what the impact of weakness in subprime will be until the fallout reveals itself, bit by bit."

However, investors still seemed sanguine about the future of stocks. In the same article Robert Harrington head of block origination at UBS said what in retrospect seems incredibly misguided but accurately described analyst sentiment at the time, "The market isn't convinced that [the subprime issue] is going to spill over into a real liquidity crunch. It could be just a re-pricing of risk." The predominant belief among financial analysts steadfastly held that the subprime problem was "contained."

In summary, problems that were initially estimated (other than by a few with foresight) to be in the hundreds of millions of dollars a year ago, have now grown to trillion dollar proportions today. This is summed up in the March 7, 2008 Bloomberg article entitled US Mortgage Market Needs $1 Trillion. "The $11 trillion U.S. home-mortgage market needs about $1 trillion in new investment to halt a slide in prices that began last year, according to analysts at Friedman, Billings, Ramsey & Co." It demonstrated how much the appreciation for the breadth of the credit problem in the US and around the world has changed in a few short months.

But are we again drastically underestimating the severity of the problem? You will notice that the $1 trillion shortfall is limited to mortgage losses and does not include other credit markets that are suffering similar challenges. (This loss also represents less than 10% of all mortgages currently outstanding today.) Other markets include merger & acquisitions, leveraged buyouts, corporate and commercial loans, auto loans, credit card and student loans and a host of other credit markets – all of which have enjoyed support from an array of complex derivative instruments about which a very select few have any real understanding. I have yet to see credible estimates about how big the problems are in these markets.

Whatever happens, one thing is becoming painfully clear. Like a new and dreadful pandemic, this credit crunch is rapidly spreading and still no one has expressed any real estimate about how big it could eventually grow. Could it be a fear of rattling markets or that such as estimate could become a self-fulfilling prophecy? It is certainly not the kind of topic that would be welcomed by the political establishment in an election year.

Perhaps for the same reasons no one has discussed how much this situation will be exacerbated by job losses and continued slowdown when recession hits the US and other industrialized nations – an outcome that is now looking increasingly likely. But pretending it doesn't exist will not make it go away and has the potential to instead make the problem larger than it could have been - if that is possible.

Disclosure: None

Comments

[nukldrager]

Without jobs, credit doesn't work. Without credit, America doesn't work.

[Matt Blackman]

Good point. The last time I checked total credit market debt in the US was more than 320% of GDP and growing rapidly. Total credit market debt is debt at all levels from government and corporate to private. But those figures did not include the huge run-up in mortgage debt that occurred in 2006 and 2007 and when GDP starts to contract, the percentage of debt will swell.

But the real point is that credit rapidly became an integral part of financial life and there is now a large black hole of which only seeing a small part is visible. Whatever happens, this promised to get very "interesting"... in the coming years! What I was attempting to point out in the article is that we are just in the first inning of a double header.

Matt Blackman
TradeSystemGuru.com

[nukldrager]

Well that's encouraging. A double header is preferable to disappearing into a black hole for those of us still far enough away from it's vortex. But since they can gobble entire galaxy's in a fraction of a second, and no one understands them, I like the metaphor here.

[Inquiring Mind]

This is a pretty minor point, but the rating agencies don't actually pronounce 70% of the CDO collateral to be AAA -- they determine(d) that 70% of the bonds issued by the CDO and backed by that collateral deserve AAA ratings. And they do that based on their assumptions about the collateral performance, which in the last two years were disastrously wrong.

More to the point, another reason we haven't seen the end of this is that the major CDO underwriters often held onto large chunks of the supersenior classes of their CDOs and used those bonds as collateral for other deals -- swaps, loans, etc. -- for which there's a certain collateral rating requirement. So when the formerly AAA supersenior CDO class gets torched, they have to pull it back and put up other collateral in the same face amount, forcing them to book the loss on the CDO. This process is still just beginning to happen as the AAA CDO classes get downgraded.

[Stocon]

OK they way I understand it is that someone created and bought these time bombs fully knowing that in a slow down or in a contraction they would wreck havoc. I mean wasn't there full disclosure about the risks of these CDOs in various market environments and the brightest minds in finance understood this? Aren't these things in pensions and related to money markets? Shouldn't somebody be going to jail? Am I missing something here?

[nukldrager]

Exactly. Unless there is such a thing as sanctioned corruption, these guy's had to have entertained the idea that they would end up with a lot of real estate by default, before the loans were marketed. Shooting fish in a barrel. Now they get a tissue and a bailout, and the tuition for the consumers who remain haplessly enrolled in the school of hard knocks keeps going up.

[Matt Blackman]

As Jim Grant said in his March 2007 interview, the CDO creators and rating agencies built their models that basically discounted the probability for a real estate price meltdown (since median prices had not dropped significantly since the Great Depression). There were no contingencies for such an event as evidenced by the fact that a large number of SIVs did not have accompanying mortgage documents (which is now rendering them unenforceable in the courts). In other words, such an outcome was considered a black swan event when such events were determined to be near impossibilities.

My contention is that mortgages represent a relatively small part of the total $530 trillion derivatives market that has been built on similar assumptions. Like a black hole, few have any idea how these instruments work and what will happen when the unexpected happens.

[nukldrager]

Like a $530 trillion house of cards? We need to get the economy into the hands of the third pig, and get the first two out of there.

[Stocon]

Jeez, this real estate downturn is hardly a meltdown and mild so far compared to early nineties. Banana republic??

[curious cat]

matt, that's a fine article, but what does grant think now?

[Matt Blackman]

Curious cat. Here is the latest Bloomberg interview between Grant and Pimm Fox from March 28...

Jim Grant on Bloomberg
Fed Balance Sheet "An economic nightmare."
www.bloomberg.com/avp/...

If the link doesn't work, you will find it at the end of the March 28 weekly newsletter at tradesystemguru.com/co.../

[Matt Blackman]

Nope. The Bloomberg link to the Jim Grant interview didn't publish properly. Here is the direct link to it on my March 28-08 newsletter

Jim Grant on Bloomberg
Fed Balance Sheet "An economic nightmare."
tradesystemguru.com/co...