So basically, all of the panic of last week (market was flat) was to simply to make sure that the patient, who has a serious illness, survived the ICU long-enough to make it to surgery. Not even off the critical list. It's not the beginning of the end, it's just the end of the beginning.
[A friend calculated a hypothetical based on [breakeven = U.S. homeownership penetration times median price times foreclosure rate times forecosure loss times equivalent monthly mortgage payment] in which the government paid for 6 months of mortgage payments for homeowners in foreclosure: ]The $135bn you calculated provides for 6 months of covering mortgage payments for distressed home"owners". Give them time to do what, exactly - sell without losing money? To whom? It won't change the underlying issue, which is a $200,000 mortgage on a house worth $150,000 (based on normal historical ratios of income, rent prices, etc). This is a solvency problem, not a liquidity problem - unless the asset or debt values change, the problem will still be there. Bidding time just prolongs the agony - Japan tried that and spent a decade on their ass.
Based on your figure of $3 trillion in defaults (probably not a bad guess) - a bank losing 30% on a foreclosure is probably fair ($1 trillion). The Case-Shiller index has current real house prices at 2002Q4 levels, and will be a total loss of 30-40% peak-to-trough. Add in costs, and that points to a cost to debt holders of $1 trillion (Another thought to ballpark the residential mortgage losses: ~$2 trillion per year in mortgage originations, 2003-2007 = $10 trillion new mortgages. 10% bad debt in there? Sure.)
Although slow to become accepted, the $1 trillion-in-actual-losses (not face value of needed liquidity) is now a FLOOR for losses (IMF, respected economists). Global write-offs through August were only ~$500bn so far.
That means there is another $500-1,000 billion still left to write down, and that's just for mortgage assets.
Unfortunately, the problem is not just mortgage assets, it's ALL levered-debt (which as we saw last week, causes liquidity runs even on 'cash-equivalent'). Double-digit trillions of dollars of notional risk is being de-levered, and trillions of equity is being re-allocated (or mis-allocated, or nationalized-and-wiped-out, or whatever Paulson decides to do this week).
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The real problem is not liquidity, it is solvency. The lack of solvency at major institutions has caused panics and runs. Liquidity can help tide over the runs, but doesn't fix the insolvency.
Assuming the Treasury pays something close to FMV for the troubled assets, that doesn't fix the bank's balance sheets. And if the Treasury buys assets at a premium to FMV, then that is a hidden recapitalization of the banks by the taxpayers, in return for no equity stake. Which is why Paulson's plan is getting nowhere in Congress.
There are hundred of billions of private equity waiting on the sidelines, ready to feast on the carcases of fat and greedy (over-levered and risky) balance sheets. But that money won't buy in if the price isn't right, and they haven't bought in yet. That should tell you something. No banks want to pull the trigger on selling assets at 25%, because they are carrying them at 50% and ARE STILL BARELY SOLVENT. Sales at FMV would immediately cause many more banks to be insolvent. And set the market for the rest of them (meaning more writedowns)
There is $3.5 trillion in money market funds, the routine flow of which provides the daily liquidity the world depends on. $90 billion was withdrawn on Wednesday alone. That is what caused the panic last week, much more so than Lehman and AIG - it was a huge and growing run on the banks which would cause a total engine sieze within days. The TED spread, the measure of basic market risk (Treasury vs. EuroDollar, or excess of LIBOR over T-bills), is normally at 50-ish basis points. Last week, it peaked over 300, the highest since 1930s. The market was about the implode for lack of liquidity. But assuming liquidity is infused and the runs stop, there is still the solvency problem of the financial institutions.
Then there is $50+ trillion in notional CDS risk, on the back of something like $1 trillion in underlying equity. Nobody knows the true net position on all of these - if AIG went down, then all those CDSs were going to start unraveling in a big way, which would lead to huge losses recognized on balance sheets across the globe, triggering more financial institution insolvencies. Liquidity would help here, too. But leverage allows small issues to become big problems, and the global CDS framework is basically too levered and too complex for any individual or entity to understand the net risk of. No one knows how CDSs will perform under such stress - that could wipe out hundreds (hopefully not thousands) of billions of additional equity. Liquidity, solvency, opacity? Who knows.
So all of last week, in which the markets were basically flat, was all to save a liquidity implosion that would have torn the financial system apart. But it did nothing to force insolvent companies to de-lever and raise capital, and so it didn't fix the problem. Just made sure that we got through last week.
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The Treasury plan now includes troubled 'financial assets', not just mortgage assets. The problem facing the financial system is not a sub-prime U.S. mortgage crisis, it is a global credit crisis with Wall Street at its center, which has led to a U.S. financial system crisis.
From Nouriel Roubini, who has been dead-on for several years in forecasting the evolving series of events: “Reckless people have deluded themselves that this was a subprime crisis. But we have problems with credit-card debt, student-loan debt, auto loans, commercial real estate loans, home-equity loans, corporate debt and loans that financed leveraged buyouts. All of these forms of debt suffer from some or all of the same traits that first surfaced in the housing market: shoddy underwriting, securitization, negligence on the part of the credit-rating agencies and lax government oversight. We have a subprime financial system, not a subprime mortgage market.”
The global rise of 1 billion people from poverty to middle class in the past two decades has generated an estimated $20+ trillion in new wealth, which had to find someplace to go, and when that kind of money comes online chasing a fairly static pool of assets, it inflates the price of assets and comes at a very cheap price. Some found it's way into national infrastructure projects (not here), some into emerging markets (Shanghai, Hang Seng, Russia), but a whole lot of it found it's way into the pockets of spendy Americans, who had no problem borrowing this cheap money to the hilt. The U.S. has saved less than zero percent rate for the past 5 years (negative savings rate). Without withdrawals from inflated home equity, U.S. GDP would be essentially flat for the last 5 years. And yet we kept spending like no tomorrow. Household debt is through the roof.(which you can't fix because you tapped out your home equity to buy a plasma TV and go on vacation).
What's next? Basically no growth for the next presidential term (4yrs). Alt-A and Prime foreclosures picking up in 2009Q1, home prices continuing to fall thru 2009, mortgage assets (even in a liquid market) generating huge additional losses, hundred of local and regional banks fail next year (costing FDIC $100+ bn), the U.S. is in a global recession for the next 12-18 months, long-term GDP growth decreased by 2% for the next several years ($1 trillion missed). Millions of more workers unemployed. And that's if things don't go completely to hell.
The next President is going to be severely hamstrung - basically he can't do anything: must increase taxes, no healthcare reform, no Social Security reform, no needed infrastructure investment, slow or no growth.
- Steve
