Global Capital Asset Death Spiral 26 comments
-
Font Size:
-
Print
- TweetThis
About a year ago the US market starting seeing large asset write downs in the housing and financial markets. Since then, this crisis has spread to almost every asset class in the US. Auction Rate Securities [ARS], like student loans back fully by the US government that can't be sold. The Auctions for these cash equivalent assets have no bids. The same is true for all types of structured investment vehicles [SIV], like packaged mortgage securities [CMOs] and debt securities [CDOs]. Homes prices have falling over 10% on a national basis, the most since the great depression. Equities all over the world have fallen 20% or more.
Money is not rotating in and out of different asset classes. We are seeing a global Capital Asset Death Spiral [CADS]. As the FASB rules require firms to mark to market assets in markets that have no bids or liquidity such as ARSs, CDOs, and CMOs, these firms must write down their asset bases. Many of these financial firms will now be forced to sell assets - good and bad, for whatever price they can get - 20, 30, 40% of book value. So now good and bad assets have very low prices set on them forcing other firms with similar assets to also write down their asset bases, on and on and on...
Firms need to sell assets at reasonable prices to raise cash - not borrow money or dilute shareholders
Recent news of the Freddie (FRE) and Fannie (FNM) government takeover does little to stop the CADS. Institutions around the world are being forced to raise capital since their asset bases are being destroyed since there is no market for previously liquid assets. These firms do not need cash, they need to sell their assets(at, or near current book) for cash. If this asset death spiral continues, the US will move from a recession to a 1930's type depression.
One could argue that we need to allow free markets to solve this problem. I would agree with this if the asset death spiral were caused by free market systems. As I will explain, the previous credit bubble and current asset death spiral were caused to a great degree by actions and inactions of the federal government.
The large credit bubble created from 2003-2007 and CADS had the following causes:
1) Historic low 1% fed funds rate
2) Poorly targeted tax cuts for the wealthy
3) No lending oversight or evaluation
4) FASB mark to market rules
My theory is fairly simple. Too much liquidity chasing an ever shrinking yield. After the US depression in 2001-2002 the federal government lowered the funds rate to 1% and kept it there. Wealthy investors were stumped. With short and long term risk free yields at pathetic low levels cash was getting very hard to invest. Investors were still hurt from the stock market crash, so these investor would not put their cash in equity markets. Then the US gave large tax breaks to these wealthy investors, giving them even more cash per year to handle. What to do with all this cash?
The combination of historic low yields, fear of equities, and a poorly targeted tax cut had created a HUGE increase in the demand for a stable return on all this cash. Can you say SIV, or CMO? Where you have demand supply will not be far behind. The larger banks and investment firms increased the creation of these SIVs with CMO and, CDOs to satisfy the large increase in demand for yield. A 5-6% yield will do just fine in this now low yield environment. Banks would now bundle 1000's of mortgages to create these new higher yielding financial vehicles.
To satisfy this large increase in supply of SIVs, lending standards had to fall. There is no other way to meet this new demand for yield, much to the glee the home builders, mortgage lenders, house flippers, etc.
The US solution - The Asset Investment Fund
We need a resolution trust type fund to invest in the US economy. An original funding of 300 - 500 billion would be needed. This fund would buy CDOs, CMOs, ARSs, developed land, raw real estate, and foreclosed property. These assets would be help the the government 5-7 years then slowly sold back into the market, probably at a profit for the US taxpayer.
The US can borrow money very cheaply , below 4% currently. Our trading partners such as Saudi Arabia, Russia, China, Canada, etc. would help as a strong US economy is in their best interest as well. The average yield of the assets purchased by the US investment fund would be greater than 6%. A positive spread of 2% could be realized for the US. Remember the money needed for this fund will be borrowed cheaply, not come from taxpayers directly.
By investing in these assets, the US will initiate market liquidity and create stable pricing environments for capital assets. This will help the US avoid having to infuse billions of dollars in GSE bailouts and avoid the many FDIC insured bailouts in the future. By investing 300 billion upfront, the US could avoid over 300 billion in bailouts over the next 2 years!
But what about the poor US taxpayer?
I can already hear the fear mongers. A US investment/bailout will just hurt the US taxpayer. If the asset death spiral continues, the US will not have many taxpayers left. State and local municipalities will not be able to raise funds as bonds can't be sold and home prices continue to fall. We will continue to see local government declare bankruptcy along with many regional banks. The remaining banks will be unable to fund ANY projects, even ones with solid cash flows. With no financing available jobs will continue to be lost, creating more home foreclosures and the death spiral continues....
This investment fund will restart the financial systems and help create jobs and insure a solid taxation revenue base for the future. This is the definitive issue in the US economy. If this US investment fund is created I see the following equities to benefit the most:
- American Capital Strategies (ACAS)
- American International Group (AIG)
- Bank of America (BAC)
- Citigroup (C)
- E*Trade financial (ETFC)
- XL Capital (XL)
This is a small list of firms that have been severely punished because of capital asset price declines over the past year. Many other firms that own ARS or SIV will benefit as well.
Disclosure: Long ETFC and ACAS.
Related Articles
|
-
The Seeking Alpha 100
See allThe top 100 stock
market authors
selected for publication
Seeking Alpha 100 » -
Fastest Climbers
Authors with the largestSee all
increase in followers
in the last 7 days
Fastest Climbers » -
Top Commenters
Top commenters,See all
as ranked by their peers
Top Commenters » -
Top Instabloggers
The 100 most active
Instabloggers.-
1
David Fry
-
2
TraderMark
-
3
Don Dion
-
4
Cliff Wachtel
-
5
Mike Havrilla
Top Instabloggers » -
1
-
Top StockTalkers
TopSee all
StockTalkers.
Top StockTalkers »
This article has 26 comments:
Fasb 157 was created in part because firms such as Enron. The gov't can't stop fraud with new regulations IMHO. My article was not blaming the theory of mark to market, just its apparent inflexibility. If some markets have ZERO bids - then what is the real value?
If your home is worth around 250K, but the person next door goes bankrupt, and the home goes into foreclosure and sells for 20K - does that mean the new value of your home is now 20K?
"[A]t the end of the first quarter of 2008, the Company held an investment in a commercial real estate collateralized debt obligation (CRE CDO) which had been depreciated $209 million from its inception to date, including $160 million in the first quarter of 2008. The investment is currently producing approximately $8 million per quarter of cash flow but its current fair value determined in accordance with GAAP is $11 million due to a lack of liquidity in the financial markets for CDO investments which has caused investment spreads to widen. However, the Company anticipates realizing its $220 million investment on settlement or maturity based on its assumptions of future credit losses, which includes a recession over the life of the investment.
via ACAS' Form 10-Q filed May 6, 2008."
I'd say yes. If it were worth more, wouldn't someone have stepped forward to pay more for your neighbor's house?
Have Freddie or Fannie missed any payments or obligations? Isn't this really a liquidity issue that the Fed is trying to keep from being a margin call?
Remember the headlines that 2008 Q2 would be flat or no growth but came in with growth that is not at all recessionary? Maybe a little positive attitude will cause a little more positive real estate market.
In my opinion, the fairest way to settle the credit squeeze is for the government to give a tax credit of 10% for individual savings. This will make a lot of investment money available, and help the credit squeeze. It also gives the poor an opportunity to benefit from being part of the solution.
Just the facts.
My idea is that the asset owner(home owner), should be allowed to value the asset using a cash flow model. In the above 250K home selling for 20K, one more data point is in that area the new rents for these homes is 2,000 per month.
Now using the PV of future cash flows the home would be worth more than 200K. This is the same as the cash flow example I provided from ACAS......
So the only difference between their CDS contracts on RMBSs and the other categories of assets is that there exists a market for them, albeit an illiquid one. Does the existence of a market really change the value of an asset? If everything was marked to market then AIG would be insolvent since it can't easily sell its insurance contract on an Eastern European charcoal factory or that policy on an Algerian oil rig. No one else has done the due diligence to know the value of those assets and so no one would buy without a large haircut. But does that mean they are worth less than par? Similarly, if there was no market for RMBs, then AIG could mark up its CDSs on RBSs by about $15B, even with conservative assumptions on loss estimates, and it would be in great financial health.
The situation is the same with the banks. Their loans are not marked to market but rather are marked down only when collection becomes doubtful. Should they be marked to market? If so, then every bank is insolvent right now and in fact would be insolvent just about anytime.
So mark-to-market cannot be the right answer for many assets. You need to consider whether the market is liquid and normally functioning. If the cash flows do not appear to be impaired but there are just no possible buyers then you need to reconsider. As Bill said, a religious observance of mark-to-market can lead to a death spiral that doesn't help anyone. I think time has come when you say, "enough is enough". There has been plenty of punishment dealt out already and so I don't think moral hazard should be our first priority as a nation right now.
While I agree with you that the FASB rules exacerbate the problem, I disagree that the blame for the meltdown in these asset classes is due to any of the 4 reasons that you mention. The fed funds rate is a SHORT-TERM RATE only. Most mortgages are tied to the secondary market for various Treasury maturities. For example, a 30-year mortgage is tied very closely to the market trades of the 30-year Treasury bond. You claim that the tax cuts were for the wealthy and were poorly targeted. Can you back up this claim? You offered no evidence to back this up. I can offer evidence to the contrary. First, most of the tax cuts were given across the board at all income classes, they were not targeted to the rich. The rest were actually targeted to low and middle income taxpayers. For example, do you remember the marriage penalty (when two individuals paid more tax if married than if just living together)? Our politicians told us that they eliminated the marriage penalty. The reality, though, is that the marriage penalty was eliminated only for married couples earning LESS than $128K per year combined. If you make more than this, then you still pay the higher marginal rates. Tax revenues actually increased and unemployment went DOWN after the capital gains tax cuts. You said that there was no lending oversight or regulation. I disagree. There was indeed oversight AND regulation. Unfortunately, there was an extreme amount of pressure exerted on the lenders by certain members of Congress representing economically disadvantaged constituents to LOOSEN lending standards.
The real reason that we are in this mess is China's unfair trade practices. By artificially setting the Yuan to a fixed exchange rate, the trade imbalance was amplified. China was holding massive dollar reserves and was buying MASSIVE amounts of U.S. debt. This in turn artificially held mortgage rates low, driving home asset values much higher than they would have. If China's currency was free-floating, the currencies would have adjusted, U.S. inflation would have been much higher, China's dollar reserves would have been miniscule in comparison, they would NOT have purchased so much U.S. debt, and therefore FED FUNDS rates would have been way up (to fight inflation) AND mortgage rates would have been up (because of inflation AND because less demand from China for the U.S. debt on the longer maturities).
That's my story and I'm sticking to it.
AP
When I was a kid, I remember thinking that what you did in your 20s is that you saved up your money so that you could afford a down payment on a house once you got married at say age 30. However this way of living changed with the new high-debt lifestyle that has grown up in the past 30 years or so. Mortgages became easier and easier to get. Also people were given more credit via credit cards and so could avoid defaulting on their mortgage by borrowing on their cards. The result was a long period of low defaults and low losses as houses appreciated steadily. Low loss rates leads to further loosening of credit standards which allows the next round of bad borrowers in.
This goes on and feeds back on itself. More demand for housing leads to higher home prices which leads to low loan losses and more bank profits which allows (and requires) more loosening of standards.
The result is the final boom and bust of the last five years. The low interest rates played an encouraging part but I think the main cause was just a loosening of credit and the way new buyers entering the market place skewed the supply-demand balance. I would say the low long-term interest rates was more an effect of high profits in the FIRE sector but the Chinese vender-financing of US consumption also played a major part.
The problem here is clear heads. Nothing has changed in the world we are all the same people with essentially the same problems we had before this crisis. This is an over reaction that may cause all of us great harm. Buy stocks!!! Quit being over-reactionary and insisting the sky is falling.
Thanks for the input. The fed's short term rate of 1%, lead to very low savings/fixed income rates - which lead to the extra demand for SIV's. Also mort rates of 5%, and more importantly, HELOC rates of 3-4%.
I agree China's Yuan was fixed too low, but this has benefits to the US also in lower inflation. I agree with you that China must float the yuan in free markets - they are big boys and girls now - no need to manipulate.
I fully think the Bush tax cuts for the wealthy also had a hand in the over use of SIV's as described in my article. One can plot the tax cut cash benefits and the amount of CMO type investments and mortgage volume. My opinion is that tax cut should be broad, and focused on the segment that will spend these extra dollars, not put those dollars into SIV's!
Dave;
Thanks for the input. I did not know those specifics on AIG, but I do feel if the US investment fund is created, AIG's stock will soar. I also have seen the change in the housing market over the past 15 years.
Today everyone feels they need to own a home right out of high school! There is nothing wrong with renting for 5 or 10 years, then putting 10% down and buying....
Jeff;
I like equities right now - great valuations. I am not "the sky is falling" perma-bear. I am just sick of seeing our government using all these backdoor methods and bailouts to try and solve the CADS.
The US needs to invest in our financial system and help everyday citizens, not bail out all the super rich counterparties of bear sterns, freddie mac, CFC etc.....
However, I disagree with the Fasist plan to nationalize everything and save the wall street bond holders and the rest of the thieves who got us here. Housing prices need to fall to 25% of their current value or less so the whole economy can get in line with wages. There will be a problem with the Chinese (and other Sovern Wealth Funds) using their worthless dollars to buy US real estate. The government must stop printing money at the helecopter rate (at 14% 18% 20%?) and let things fall.
yes, people will lose their homes and the value will fall. They will owe more than the home is worth and someone will lose. Who ? CALPERS and the other pension funds. But they have already lost big time. The politicians and other crooks are just keeping it quiet until after November.
I am voting for the Muslim Obama so he and the Democrats are left holding the bag and even Hillary wont be able to run in 2012
I personally am short BAC right now. I imagine there is a whole lot off money in the stock who thought the GSE bailout would start a financial led market recovery. Now that it's not happening, they have to sell.
I posted my exact trade at concisetrading.blogspo.../
Ryan
On the article --
Your basic assumption that the "US can borrow very cheaply" will immediately fail, once the lenders discover that the US government is using the funds to effectively buy overvalued capital assets that have little to no liquidity. What would happen in your economic dream world if the rate the US pays to borrow money jumped to 6-8-10-20%? The reverbations to the US economy in general would be catastrophic as the US government could be drawn into bankruptcy because it could not pay back loans either directly or by virtue of selling more bonds or with the revenues generated by the tax base. Talk about a formula for high inflation!!!
Here's the acid test -> Would you buy stock or bonds to create the institution that you are proposing? If not, then why would you expect others to do so and maintain the low rates you've quoted?
For the record, institutionalizing everything isn't the answer. I am already concerned with how the Democrats will use the FNM takeover to buy votes (I can see it now ->"If you vote for Obama, he'll get you a government backed, non-foreclosable loan to buy your dream house @ .5% APR. To qualify, you must make <$70k per year or have contributed at least $2MM to the California Democratic Party.") The current plan that lets the government participate in home appreciation in exchange for foreclosure avoidance is too close to nationalization of the real estate market as it is. Remember - someone, somewhere is trying to find a way that they can benefit more than anyone else from each and every one of these programs.
Eventually, the programs will have to be paid for, with our tax dollars. You're kidding yourself if you think this can be achieved with the "profits" the programs generate. (If they could, why isn't the free market, which doesn't have to wait on Congress and the President to pass laws, already doing it??) Do you really think that they government knows how to invest your money for you better than you? Looking at the status of Social Security, can anyone say honestly that?
Reasonable regulations are good; avoidance and loopholes are bad. Let the market work within appropriate boundaries. The fact that FNM and Freddie Mac contributed to this implosion is deplorable. But they had the government's backing; if not explicitly, then ultimately, by virtue of the takeover.
Remember, people make money when the markets go down, too. So, as the market is going down, someone is making money that they'll be able to use to buy really cheap capital assets (land, real estate, etc.) Eventually, it will stop.
And on that note, bear markets will continue until investors capitulate. By virtue of this article, and the supporting comments of more government takeovers, I think we're almost there. But if every failure is going to generate a government bailout, then we've got a long ways to go. There *will* be winners and losers. Let's not let the loser be the guy who ends up funding each of these bailouts, the taxpayer. He's not even in this game.
Only aggressive prosecution of corporate executives who misrepresent or defraud will ever create transparency in markets. If we depend on the CPA's to find the needle in the haystack, there will be no hay left before they are accidentally pinched by the needle!!!!!
"..... If this US investment fund is created I see the following equities to benefit the most:
....
* American International Group (AIG)"