Scale of the expected Losses

Estimates of Losses

Nouriel Roubini, a prescient observer who forecasted in 2006 and 2007 the financial crash, believes total credit losses will be “closer to $3 trillion” than the $1 trillion to $2 trillion he previous estimated. Legendary prognosticator Marc Faber puts the total bill at $5 trillion. The International Monetary Fund put the figure at $1.4 trillion on Oct. 7, 2008. As of October 14, financial firms had reported $637 billion in losses, according to data compiled by Bloomberg.

Estimates of losses are inherently conjectural. For residential real estate, the question becomes: how many people walk away, such that the lenders absorb the losses, and how many stay in their homes, even though they are underwater? But housing is just one element of the picture. There are also credit card loans, auto loans, student loans, all of which have been hammered by the rise in interest rates. Commercial real estate, heavily dependent on the credit markets, was also driven to historic heights during the boom, with price to rental ratios reaching unprecedented levels. On top of this was overlaid the growth of extreme leverage throughout the financial system. Because of the interlocking nature of the obligations among financial institutions, the failure of several imperils the survival of all.

The great dilemma of government policy is fairly straightforward:

If financial institutions “mark to market” the various assets on their books, a great many are insolvent. To allow them all to fail would imperil the entire financial system and lead to a cascade of bankruptcies. On the other hand, to save them through governmental action risks “moral hazard” on an unprecedented scale, bailing out the foolish choices of Wall Street at the expense of taxpayers. It also imperils the balance sheet of the Federal Reserve and the US government.

The main point to keep in mind is that one cannot arrive at a just view of the government’s bailout program without considering the likely scale of the losses. The higher these prove to be, the more irrational and wasteful will appear the current attempt to prop up financials and bail out current shareholders with public capital. It is only if the crisis we face is a liquidity crisis–a short term rush for unencumbered cash–that Paulson and Bernanke’s approach stands a chance of vindication. But we have every reason to believe that insolvency is in fact at the root of the problem.

The Housing ATM and Losses on Real Estate

There are various ways of estimating likely total losses on residential real estate. Myself, I like this chart. If we return to the lending standards of the 1980s and early 1990s, when you had to put 20 percent down and get a fixed term mortgage at a high interest rate, it would follow that the equity withdrawals of the past seven years (the famed “Housing ATM”) will be roughly equivalent to the losses on residential real estate. Even if the government revives the mortgage insurers, such that households only have to come up with a 10 percent down-payment, the credit terms will not support (barring hyperinflation) a return to the prices that prevailed in the boom.

The main point: If we stipulate that it was above all a credit boom that fueled the real estate boom, the puncturing of that bubble will probably wipe out a good portion, perhaps all, of everything “taken out.” A lot of other factors–the vast oversupply of units, especially–will affect this question, undoubtedly, but I also like this “money taken out” as a reasonable metric for losses.

Another way of expressing this point is that manic conditions in the credit markets create “fictitious capital,” a term from the Austrian economists (Ludwig von Mises and Friedrich Hayek). A rough definition of the term is capital multiplied by debt and leverage. Return credit conditions to some degree of “normality,” and the fictitious capital disappears.

Extend the thought experiment: just how much value was extracted by the Wall Street money machine over, say, the last seven years? I can’t find an aggregate amount, in nominal dollars, of total financial sector profits for that period, one inclusive of reported profits, bonuses, and other executive compensation, but such a thing could be constructed with some legwork. So, in our thought experiment, let’s take that total and make an estimate of how much of the profit essentially derived from extremely artificial credit conditions, as with the “equity take-outs” in residential housing. Adjust the total profits by separating “that which is a good business in normal times” from “that whose business model was based on unlimited credit and high leverage.” Then make an estimate of potential losses on the basis of that.

Analysts have spoken, with good reason, of privatized profits and socialized losses. My thought is a bit different: that probable losses can be measured in relation to previous profits. Certainly worth thinking about. It suggests a different criterion than either “mark to market” or “mark to maturity” in estimating “total losses.”

Losses and Liquidity

What are losses? I can’t really answer that question. I get the big concept, but the details elude me. The loss of some $25 trillion from the crash of stock markets would certainly seem to qualify as a loss, but it’s not the sort of loss that people estimating losses are thinking about. They’re looking at defaults and write-offs. At least I think that’s what they’re looking at.

Next question: What is money? What is liquidity? That’s unclear to me too. One thing I do know: the old standard definitions–the now electric M1, M2, and MZM, the skyrocketing Adjusted Monetary Base, the late great M3–no longer suffice to understand money or liquidity.

In their booklet, New Monetarism (2006), two investment professionals, David Roche and Bob McKee, give an original take on the “what is money and liquidity?” question, an essential preliminary to the “what are losses?” question.

With this graph describing a “liquidity pyramid,” the authors seek to see visually the new structure of money–the new world financial order that grew up over the last decade, now breaking. It is a world that is emphatically not captured by the traditional measures of money.

“Today global liquidity is like a massive pyramid standing on its head,” they warned two years ago. “It represents at least ten years of GDP and is growing at least five times faster than GDP.” There are four levels:

a) “At the bottom of this inverted pyramid is a tiny triangle of central bank power money.”

b) That expands into “broad money,” basically the only form of money recognized forty years ago.

c) “On top of broad money now comes a much bigger slice of the liquidity pyramid, composed of securitised debt markets, where much traditional bank lending now gets sold off as bonds.”

d) “Finally, at the top come the massive derivative and other exotic asset markets, compromising nearly 75% of total global liquidity.”

This was written in 2006. The term “inverted pyramid” was meant to suggest that the system could not long stand and would soon verify Minsky’s hypothesis that a lengthy period of stability led inexorably to instability. They were right.

There is another important implication. The way we measure money, inflation, unemployment is so skewed by political convenience and bureaucratic habit, to say nothing of fossilized imaginations, that the reported aggregates are often worthless and usually misleading. Beware constructing theories on the basis of these official statistics. Students must frequently dig into the assumptions behind reported statistics in order for them to be at all useful.

So there we are. The “shadow banking system” is not captured in the traditional monetary aggregates, just as inflation and unemployment are not adequately captured in government statistics, with their convenient methodological adjustments.

Citizens! You are justly angered by the malefactors of great wealth! Spare some annoyance, at least, for Washington’s misleading statistics.

10/25/08

Preparing for a Rainy Day?

As the banks were taking ever more dubious loans onto their balance sheets, or hiding them off their balance sheets, as with the notorious SIVs, were they setting money away for the inevitable turn of the credit cycle?

Of course not. This chart from Barron’s, though dated, shows the general tendency.

Household Debt as % of Compensation

Estimates of losses cannot escape reckoning with the fundamental disparity between household debt and total employee compensation (wages, salaries, pension contributions). The same disparity, with a different formula, is expressed here. The total debt of American households was 79% of total compensation in 1978. It had more than doubled to 174% in 2008. “The problem is quite simple, all over the West,” explains the blogger Hellasious (“Hell as IOU’s’) at suddendebt.com. “There is too little earned income at the foundation of the economy to support massive debt and thus overinflated asset prices.”

In the right hand column of my blogbook is a mortgage calculator. Most college students are probably unfamiliar with how that works. But you will find out, one of these days. You should fiddle around with it, keeping in mind the ratio in the above chart. So:

* make your imaginary calculations in relation to the income levels of representative groups of Americans,

* make note of the difficulty faced by households in raising downpayments on a home (because of low household savings and falling values in the equity and real estate markets, where most household wealth is registered),

* then throw in the rising level of long term mortgage rates,

* and draw your conclusions.

Monday

The Importance of Being Credit-Worthy

This chart, from data gathered by Albert Edwards, shows that tightening credit and worldwide default rates are soul-mates. Edwards’ view is that a deep global recession is inevitable. He calls it “The Vortex of Debility.” Nice phrase, ugly prospect.

A Comparison with Japan

The spectacular fall of Japanese markets after 1989, in which land and equity prices followed one another down in a long spiral, inevitably suggests comparisons with the contemporary American predicament. But the comparison provides no cause for optimism, for Japanese households, at the height of the bubble, had a high rate of domestic savings of 15 percent of household income. Yet this cushion did not arrest the fall in equity and real estate values. Household savings, calculated without reference to equities and real estate, have been zero for some time in the United States. And household finances are deeply impaired by high debt and collapsing asset values.

Keep this chart in mind as we go forward and survey US responses to the crisis.

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Scale of the expected Losses

Monday

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