Economics Tricks

The financial contagion of the sub-prime mortgage crash continues to work its way through the nation's economic foundations like dry rot.

But to put the blame on mortgage lenders, banks and the like is to mistake swelling for the fracture. The U.S. economy is out of sorts at a very fundamental level - and the result is that we see municipal bond (bonds issued by cities and schools) market collapse at both the level of the insurer and at the lending window itself. The entire auction rate securities market, an obscure flavor of government bonds, including some issued by the Denver International Airport and the City of Aurora, has interred itself for a lack of buyers. Interest rates for cities and, by extension, their taxpayers, have skyrocketed. The entire ARS market, as large as $342 billion, has literally evaporated. If you hold an ARS bond, you literally can not sell it today. Yet the mainstream media, and public-at-large, have heard little of this.

This trapped capital is yet one sign of how bad the American economy is right now. Those billions mean higher credit card rates, student loan payments, future mortgages and car loans. What has traditionally been a very low risk market, municipal bonds, is now a bad joke. And job creating projects - roads, schools, bridges, hospitals - are now at risk. One of the core reasons for the credit calamity traces itself back to the federal budget deficit and the twin hallmarks of the Bush era - tax cuts, followed by deficit spending and the $3 trillion Iraq war. This huge debt, financed largely by China in service of a massive trade surplus with the U.S. - has knocked flexibility out the American economy The basic equation: buy cheap products at Wal-Mart from the Chinese. The Chinese, with their fixed-rate currency system (part of the reason their goods are cheap) then turn around and invest those dollars in American debt. Because the Chinese can't reinject the full value of their profits into their economy without causing hyper-inflation, largely because their fixed-rate currency can't adjust relative to the dollar, both nations are trapped in this worsening spiral.

This in turn weakens the dollar internationally, which causes energy (and food) prices to go up, out of proportion with fundamental costs. American wages stagnate. In January, American wages suffered a real dollar decline. Savings and investment go down, creating a negative feedback loop which tightens credit.

The answer, which is uncertain at best, is that we must get debt, both personal and federal, under control; reduce our spending on energy; and re-invigorate the core of the American economy by boosting productivity through innovation, and keeping jobs at home.?

The Bank of England's monetary policy committee (MPC) has opted to leave interest rates unchanged for the remainder of this month, it has emerged.

Standing at 5.25 per cent, the base rate of interest attached to mortgages, loans and other forms of borrowing is to stay consistent until the MPC's next meeting in early April. The announcement follows the 0.25 percentage point reductions seen both last month and in December. The rate now stands at the same level as seen in January 2006.

For many consumers the news could be welcomed, as homeowners may discover that their mortgage providers will choose not to increase their monthly repayments.

However, David Kuo, head of personal finance for Fool claimed that today's decision is likely to be "very disappointing for homeowners". He suggested that in particular the estimated 1.4 million people who have a fixed-rate mortgage deal due to end in the coming year will come under pressure. The financial expert suggested that if they are unable to switch to a new fixed-rate contract and have to gone on to their money lender's standard variable-rate deal, those with a 100,000 pounds mortgage could see their monthly repayments surge by around 200 pounds.

Following on from such an increase it is possible that people may develop problems with meeting other demands on their finances such as personal loans, credit and store cards, utility bills and transport costs. Mr Kuo claimed that such consumers must take steps to reduce pressure on their finances. He said: "People who can't switch may have to drastically cut their household expenditure to afford the higher repayments. But rather than wait for the inevitable to happen, homeowners can overpay their mortgage now by exploiting the time before their fixed-rate deals end. Making additional monthly payments of 200 pounds on a 100,000 pounds mortgage will cut the outstanding debt to 95,550 pounds instead of 98,000 pounds after twelve months. Apart from reducing future repayments, it will put you in a better position when you remortgage."

The personal finance head also reported that as the availability of cheap loans and other forms of competitively-priced credit begins to fall, consumers need to take "active steps now" to make sure that they are getting the best deals possible.

Chief economist for Lloyds TSB Trevor Williams added that the maintaining of the rate came as the Bank looks to balance against a predicted economic slump and inflation rises. He also cited research which indicated that last month saw an increase in manufacturing and services activity after a period of slowing growth during the previous 12 weeks. Meanwhile, Mr Williams claimed that money supply surged to 12.9 per cent. The financial expert suggested that, due to such figures, the MPC may choose to maintain rates for several months as the economy is "still far from recession". However, he did point out that consumer confidence is diminishing and the property sector is "flattening".

After today's news, it may now be an ideal time for many consumers to apply for a loan. With interest rates potentially set to be left unchanged for a period of time, prospective borrowers may discover that they are able select a low-cost loan which leaves them with affordable repayments to make each month. This may be of particular assistance to those struggling to afford the various expenses of buying a home. Recently Moneyfacts reported that the number of money lenders offering loan-to-value rates of 100 per cent or more has fallen during the past three months.

The last three tax cuts in the capital gains rate, 1979-1982, 1997 and 2003 saw government revenues soar, even as Democrats flooded the networks with talk of revenues that would be lost from lower rates, as did the Congressional Budget Office, which has a history of low-balling the yield from tax cuts when proposed, then, each time has to report the higher numbers as they roll in.

Democrats detest tax cuts.

In 1987, the rates went back up and revenues fell off the table. Revenues did not get back up to their 1986 level, until the rates were cut back down in 1997.

Not just in the United States at the federal level and statewide, have economies thrived as government revenues soared; it's been a worldwide phenomenon and one that goes back many decades.

Perhaps, the United States is the only country where such blatant lying about it, goes on.

After WW 2, both Japan and Germany were recovering from the war in stops and starts until enacting major tax cuts. In each case, tax cuts were the catalyst that fired their economies.

The premise is simple enough for grade school students to easily comprehend, yet those who want us dependent on government, ignore the truth as easily as combing their hair.

Tax cuts for business and investors, free up working capital to, among other things, buy new equipment, increase advertising, hire additional employees, take advantage of new technology, computers for example, often increasing productivity, thus increasing profits.

In some cases, companies avoid going out of business, continuing those jobs, already in place.

When the positives of retaining more individual or business earnings, kick in, a broadened employment base plus higher wages and higher profits, yield higher revenues to government.

There is often a lag after the cuts. The increased revenues, may, take time to first replace those lost and eventually surpass the previous amount. All the while, the stimulus puts more people to work, who purchase more goods. Conversely, higher taxes, like higher prices result in less consumption. When the price of computers, for example, came down, millions more bought them.

The 2003 Capital Gains Tax Cuts

Looking at the most recent capital gains cuts, which took place in 2003, revenues from capital gains in 2002 had been $49 billion.

In 2003, the first year of the cut in the tax rate from 20% to 15%, the lower rate yielded slightly higher revenues than in 2002, increasing from $49 billion to $51 billion. By the second year, the lower tax rate saw revenues soar to $101 billion.

Congressional Budget Office (CBO) estimates, not yet finalized, are for revenues of $117 billion for 2006 and $127 billion for 2007, just about triple what they were in the last year of the higher rate.

This time we did not have to wait for higher revenues, the increase took effect in the very first year.

So now promising to pay the additional costs of universal health care by increasing taxes on the very capital that increases revenue, is false and shameless.

Universal Health Care will have a "net final cost" of hundreds of billions, each year, guaranteed to add to the national debt which the Comptroller General is almost begging congress to bring under control, before adding huge new burdens.

The damage done by this kind of populist rhetoric over the centuries has probably been the single biggest destroyer of nations.

Through most of its history, most Americans faced the fact, that hard work and persistence were the true solutions to the American Dream.

Today, reliance on the nanny-state and redistribution through government has far too many believing they deserve the fruits of work done by others.

This article is a successor to an article I wrote on October 11, 2007 in which I suggested that the credit crunch would be far worse than most people believed and that the impact on the stock market, the financial system, economic vitality and inflation could be significant. Now it is the week after Thanksgiving weekend and as I contemplate last week's market sell-off and this week's dramatic rally, I realize that the stresses have grown more evident and I can't help but contemplate what might now be in store for next year.

On the positive side we are almost six years into an expansion and the US economy continues to grow albeit at a slower pace. Unemployment remains low except in sectors related to housing but it is edging up. Corporate profits have been good this year but they declined a bit in the third quarter. Until the first full week of November the stock market indices were at or near all time highs, though of late trading has been increasingly volatile. The credit crisis of August now seems to be just a problem for the financial sector to manage. The Fed has lowered interest rates three times indicating it wants to protect the economy. On the surface things are looking OK.

But look under the surface and the picture changes. The credit crunch has lost its crisis atmosphere but many sectors of the credit markets remain paralyzed. This paralysis is now affecting businesses and consumers in areas other than real estate. Equity investors are nervous as evidenced by the stock market's extreme volatility. The Dow was 1,000 points off its all time high and the S&P 500 was even down year-to-date, though both bounced back on interest rate cut hopes. The housing market is in a deep recession moving towards a depression. Declining home values are siphoning off vast amounts of consumer wealth while rising food and energy prices are eating into family budgets. Unemployment is edging up in many states and consumer confidence is at a two-year low. Consumer inflation is 3.6% year-to-date and edging higher. On top of it all, we are entering an election year and geopolitical events are more unstable and dangerous than they have been since WWII.

As consultants, business owners and senior executives our job is to be aware of what is happening in the world, anticipate how events might impact our clients or our businesses and stay ahead of the curve by taking action to mitigate identified risk. We can't relax just because things are going well now. We have to look ahead at what might or might not be.

I see seven interrelated threats that business owners, senior executives and Boards of Directors should understand, anticipate and plan for in an effort to minimize the negative consequences should one or more of them become a reality. The principal threat is the growing credit crunch because depending on how it ultimately unravels it could lead to any one or more of the other six - depression, recession, inflation, stagflation, legislative action unfavorable to business and geopolitical crisis. This is a businessman's effort to present the facts in a way that enables other interested parties to make sense of it all.

The Credit Markets

Perhaps the greatest risk to the economy and our businesses lies in the credit markets. While the credit markets have calmed down since the crisis atmosphere of August, the underlying problem still exists as evidenced by the lack of liquidity in the capital markets and the huge write downs being taken at public financial institutions. It is now understood that the ultimate severity of the credit crisis still remains to be seen, and people are beginning to recognize that depending on how it unfolds it could result in any or all of recession, inflation, stagflation and geopolitical upheaval.

It is now clear that the massive amount of debt underlying the world economic system is at risk of unwinding due to collateral defaults. At the heart of the matter are Collateralized Debt Obligations, or CDOs. CDOs are derivative securities, as in derived from another asset. Trillions of dollars of these instruments were created and sold over the past six years. According to Satyajit Das, one of the world's leading experts in derivative securities for over 20 years, $1.00 of real capital supports $20.00 to $30.00 in loans. That means each dollar is leveraged 20 to 30 times! He estimates derivatives outstanding to be $485 trillion, or eight times global gross domestic product of $60 trillion. The scary thing is that no one really knows for sure who holds all this paper.

The problem is global and there is only a limited amount the Fed or other central banks can do to manage it. This is because much of the problem lies in the unregulated shadow banking system[1] defined as the whole alphabet soup of highly levered non-bank investment conduits, vehicles and structures. The effect of securitization is that credit risk moved from regulated entities where it could be observed to places where it was unregulated and difficult to observe. Without regulators to keep tabs on cross-border flows and quality standards, investors didn't really know what they were buying or what it was really worth.

U.S. ingenuity: In the post dot com bubble and 9/11 world of ultra low interest rates, US Banks saw their net interest margins shrink along with their loan volume which negatively impacted profits. So the banks developed ingenious ways of creating significant fee income by bundling volumes of consumer (many of them low income) and leveraged buy-out loans into what are called Asset Backed Securities (ABS) to be sold to institutional investors like "bonds". The investors then use these ABSs as collateral for another high-yielding debt instrument called a Collateralized Debt Obligation. These CDOs were snapped up by Asia and Mid-East governments, hedge funds and pension funds looking for rated high-yield instruments in which to park their mountains of emerging markets cash. Financial engineers built towers of securitized debt with mathematical models that were fundamentally flawed, while managers overloaded on high-yield debt instruments they didn't understand. All along the way the banks pocketed huge fees while shifting trillions of dollars of risk off their balance sheets and into the hands of investors. It is estimated that last year alone Wall Street bankers (including the money center commercial banks) generated $27.4 billion in fee income from the origination, securitization and sale of exotic Asset Backed Securities.

Because of low interest rates in the US and Japan most CDOs were bought with borrowed money. In other words, borrowed money bought borrowed money. Because of high credit ratings the CDOs could be used as collateral for more borrowing. These triple borrowed assets were then used as collateral for commercial paper purchased by risk adverse money market funds. When the assets underlying these securities begin to default in large numbers (sub-prime loans), the CDOs lose value and the institutions holding them incur losses. And because no one knows for sure who is holding this paper everyone is afraid of taking on new counterparty risk. The credit markets become illiquid and many financial institutions end up holding huge amounts of CDOs for which there is no or limited market.

Asset Backed Security basics: Let's take collateralized mortgage obligations (CMOs) since they are the easiest to understand. In their simplest "pass through" form banks and other lenders originate loans, warehouse them for a brief time, package them into a bond, have the bond rated and sell the bond to investors. Instead of making money from the net interest margin over the life of the underlying loans, the originators earn origination fees and payments from servicing rights. Investors who buy CMOs are actually buying the future cash flow from the underlying loans' principal and interest payments. Because the CMO is rated by the rating agencies the purchase price equals the future cash flow discounted to a yield consistent with the rating of the bond. The advantage of this system to the originator is that the fees are made up front, the servicing rights provide an ongoing source of fee income unless sold, the credit risk is transferred to the investor and the investment proceeds allow the originator to make still more loans. The investor gets a rated instrument with a yield appropriate to the rating.

The role of rating agencies: Ratings on bonds convey an agency's assessment of the probability of default. Investors rely on ratings when making investment decisions because of the rating agency's track record. For instance, over a 21 year period Moody's AAA rated bonds demonstrated a .79% probability of default by year 10. In the asset backed securities world similarly rated loans or bonds are combined in a portfolio, then divided into different tranches with the riskiest tranches taking the first loss, receiving the lowest credit rating and offering the highest yield. Similarly the least risky tranche takes the last loss, receives the highest credit rating and offers the lowest yield. In this way a portfolio comprised of B rated individual securities can be packaged to offer senior tranches that receive an A or even AAA rating and junior tranches that receive a junk rating.

Bubble trouble: In recent years double bubbles drove US economic growth by providing unprecedented liquidity to the financial markets: 1) asset securitization, most notably subprime loans; and 2) the shadow banking system, defined as hedge funds, pension funds and the whole alphabet soup of highly levered non-bank investment conduits, vehicles and structures like ABSs, CBOs, CDOs, CLOs, CMOs, SIVs and CDSs. The joint growth of these two bubbles was grounded in the irrational belief that home prices would forever increase irrespective of affordability, and access to capital at low interest rates would be unlimited because holders of "safe" asset backed commercial paper would forever roll their investments. Belief in the former proved unfounded in 2007 when subprime loan defaults soared, which caused a de facto run on the shadow banking system as investors refused to roll their asset backed commercial paper holdings and demanded their money back.

Changing models, changing ratings: As sub-prime loan defaults rose in 2007, in contravention of the rating agencies' mathematical models, CMOs began to collapse. As defaults accelerated the rating agencies were forced to review their models. On July 10, 2007 the rating agencies changed their models and downgraded many CMOs. This caused panic and uncertainty among CMO investors and the contagion quickly spread to all other types of CDOs.

Uncertainty and risk: Investors believed that the default distributions of the ratings on their asset backed securities were the same as the default distributions of the individual assets backing them. After the mass downgrade of July 10^th investors concluded they were mistaken. Investors no longer knew for certain the default distribution of what they owned. What they did know was that the model upon which they based their investment decisions had turned out to be wrong. When Investors don't know what they don't know there is uncertainty. Uncertainty is different than risk. Risk can be quantified and diversified, uncertainty cannot. Uncertainty causes investors to step back with the result that asset backed securities markets are essentially frozen, bid-ask spreads are wide and "indicative" (not firm) and many investors are saying they simply do not want any ABS risk. This is a killer for the shadow banks.

Banking in the shadows: Unlike insured, regulated real banks, shadow banks fund themselves to a large degree with uninsured commercial paper which may or may not be backstopped by liquidity lines from real banks. The shadow banking system is particularly vulnerable to a run which is when commercial paper investors refuse to roll over their investment when their paper matures. That causes the shadow banks to tap their back-up liquidity lines with real banks and/or liquidate assets at fire sale prices. This is what happened in July and August as outstanding asset backed commercial paper plunged $300 billion and the Libor spread over the Fed Funds rate widened by 50 basis points. The credit markets had effectively frozen.

Cosmetic fix for a structural problem: That led to the Fed's 50 basis point cut in the discount rate on August 17^th and the Fed Funds rate on September 18^th and October 16^th which were intended to create liquidity in the credit markets. But all they did was calm the markets, not create the desired liquidity. The reasons were three fold: 1) banks hate to borrow from the discount window because the Fed has always been seen as a lender of last resort (read troubled bank); 2) the discount rate remained a 50 basis point premium over the Fed Funds rate; and 3) now that the rating and pricing models for securitized debt had proven to be faulty, the real banks were looking to decrease exposure to the shadow banks, not increase it.

Frozen Solid: As subprime mortgage defaults increased and agencies lowered their ratings, investors, banks and funds began looking at all derivative backed paper with suspicion, refusing to accept it as collateral for the short-term commercial paper that provides liquidity to today's money markets. It is estimated that 53% of $2.2 trillion US commercial paper is now backed by assets, and 50% of the assets are CDOs. That is over $500 billion in commercial paper backed by CDOs. As of November 2nd collateralized commercial paper had declined for 11 straight weeks in an amount totaling $300 billion or 25% from the amount outstanding at the end of July. Further, as much as $300 billion in leveraged finance loans were "orphaned" because they could not be sold or used as collateral (which means they have to be held in portfolio on the lender's balance sheet). Large segments of the credit markets were frozen solid.

Now what: We know how much securitized debt the public institutions hold on their balance sheets, and it amounts to many billions of dollars. But these amounts do not account for the off-balance sheet exposure these institutions have to the highly leveraged special purpose companies they set up to create, buy and trade this paper, or to the private hedge funds that borrowed from the banks and represent counterparty risk as well. In the third quarter many of the public institutions took large write-downs against the derivatives held on their own balance sheets, including Citigroup, WAMU, Lehman Bros., Merrill Lynch, Deutsche Bank, UBS and Countrywide. However, the write downs amount to only a fraction of their Level 2 and Level 3 assets[2] so the fear is that much more will have to be written down as underlying collateral defaults increase.

Indeed, in October and November the write-downs have accelerated with Citigroup, Merrill Lynch, JP Morgan Chase, Bank of America, Wachovia, Freddie Mac and others all announcing multi-billion reserves for expected losses. To date over $66 billion in provisions for losses have been announced and much more is expected. Two high profile CEOs have been fired, Citigroup and Freddie Mac have been downgraded, may cut their dividends and are raising capital to meet minimum regulatory requirements. The effect of leverage in a declining market is that losses are amplified. As value goes down other assets must be sold (usually at a discount) to maintain covenants. When derivatives are sold at a discount, accounting rules require that all similar assets in the debt chain be marked down by the same discount. This quickly drains more liquidity from the system making the global liquidity situation worse.

No one knows for sure to what extent any entity is exposed so everyone is reluctant to take on new counterparty risk. This is why the credit markets remain just one bit of bad news away from panic. The credit markets also impact the stock market which until recently had in part been driven by CDO type instruments that go under the heading of "structured finance" (LBO, MBO, stock buy-backs), by corporate liquidity created through the issuance of asset backed commercial paper and by the securitization gains reported by publicly traded banks, funds and other financial institutions. If deals don't get done, if corporate liquidity dries up or if banks, mutual funds and others continue reporting large losses on derivative securities, the market is vulnerable to a sell-off as we have seen in the first and third weeks of November.

Deflating bubbles: Thus current market volatility is more than just a correction. It is fear of a gigantic liquidity bubble deflating. The Fed cannot prevent this by lowering interest rates or injecting liquidity because the problem is not the amount of money in the system. The problem is that investors are questioning the entire risk transfer model and its associated leverage and counterparty risk. The August credit crisis did not go away, it just moved off the front page. Consider this - billions of dollars of investment grade CDOs are held by state and local pension funds. These funds are generally restricted by law to investing in only investment grade paper. What happens when the investment grade CMO held in a pension fund portfolio is downgraded to non-investment grade or even junk status? The fund is forced to sell these securities, most certainly at a discount. That is why many people who understand the extent to which the global economy has been supported by debt are making risk mitigation a high priority. These include people at the Federal Reserve and Treasury Dept.

Contagious crunch: As the business model for the securitization of subprime mortgages ceased to work, that asset class imploded. Rather than being contained as the Wall Street and Beltway authorities predicted, Wall Street soon began repricing other classes of financial risk assets (credit card and auto loan portfolios, etc.) to higher risk premiums (lower valuations). But the contagion is no longer limited to portfolios of securitized assets.

The housing recession is clearly being exacerbated by a mushrooming mortgage crunch as lenders raise credit standards and reduce loan amounts. And as the financial stress from housing makes its way into family budgets lenders are beginning to see increased credit card and auto loan delinquencies and defaults requiring increases in reserve requirements for these asset classes. When reserve requirements go up lending goes down and terms get more onerous. Interest rates, late fees and penalties go up, credit limits are reduced and grace periods are shorter. These are early signs of a classic consumer credit crunch. The trend in all credit markets toward less and more expensive credit will be a drag on the economy in 2008. How much of a drag is really anyone's guess because the subprime meltdown puts the economy in uncharted waters.

A companion article titled "The Seven Threats to Your Business in 2008" will be published this date and will explain the potential impact that the credit crunch will have on the general economy and your business specifically.

[1] Shadow Banking System is a term coined by Paul McCulley of PIMCO

[2] Level 3 Assets are those assets for which there is no market. Level 2 Assets are those assets for which there is a thin, erratic market. Because there is no reliable market value for these assets, accounting rules and securities regulations allow the institutions to determine value using internal valuation models. The result is that a CDO could be valued at .95 at one institution while at another institution that same CDO might be valued at .90.