The Bank of International Settlements issued a warning yesterday that underscored just how serious the Real Estate Bust has become.
"Virtually nobody foresaw the Great Depression of the 1930s, or the crises which affected Japan and southeast Asia in the early and late 1990s. In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a 'new era' had arrived", said the bank.
The BIS, the ultimate bank of central bankers, pointed to a confluence a worrying signs, citing mass issuance of new-fangled credit instruments, soaring levels of household debt, extreme appetite for risk shown by investors, and entrenched imbalances in the world currency system.
More below the fold.
In a thinly-veiled rebuke to the US Federal Reserve, the BIS said central banks were starting to doubt the wisdom of letting asset bubbles build up on the assumption that they could safely be "cleaned up" afterwards - which was more or less the strategy pursued by former Fed chief Alan Greenspan after the dotcom bust.
It said this approach had failed in the US in 1930 and in Japan in 1991 because excess debt and investment built up in the boom years had suffocating effects.
The bank said it was far from clear whether the US would be able to shrug off the consequences of its latest imbalances, citing a current account deficit running at 6.5pc of GDP, a rise in US external liabilities by over $4 trillion from 2001 to 2005, and an unpredented drop in the savings rate. "The dollar clearly remains vulnerable to a sudden loss of private sector confidence," it said.
Bloomberg had an article on the same report but focused on different aspects.
The possibility of a slump in real estate markets remains "a significant risk to financial stability," while the growth in securitization has spread "direct and indirect" risk across the financial system, the BIS said.
"Who now holds these risks, and can they manage them adequately?" the report asked. "The honest answer is that we do not know."
Much of the risk is contained in various forms of asset- backed securities of "growing complexity and opacity" that have been purchased by banks, pension funds, insurance companies and hedge funds.
"Hedge funds might be most exposed, since many have tended to specialize in purchases of the riskiest sorts of these instruments," the report said.
Speaking of hedge funds and subprime loans, that brings us to the most pressing financial news of the month.
Financial giant Bear Stearns, unveiled a $3.2 Billion bailout plan last week for its failing hedge funds that specialize on risky mortgages, after it lost 23% of its net worth in just four months. This is the largest hedge fund bailout since Long-Term Capital Management went bust in 1998 and almost took out the global bond market with it. The bailout failed to rescue them, as Merrill Lynch seized $800 million of the hedge fund assets and sold them on the open market.
This is an ironic turn of events. Back in 1998 Bear Sterns refused to join its rivals in the bailout of LTCM. Nine years later Bear Sterns asked its rivals for a bailout and they refused.
This comes less than two months since another financial giant, UBS, shut down its hedge fund after $120 million in losses in the subprime mortgage market. Today, a U.K. hedge fund is reporting massive losses from its exposure to the subprime market. This appears to be the leading edge of a massive financial fallout.
What is approaching is a repricing of risk. What that means is that mortgage bonds that have been repackaged and sold on the open market will be downgraded as the rating agencies finally (belatedly) acknowledge that the risk of default on those bonds was much higher than admitted when they were originally sold. That means that the organization that bought those bonds, purchased overvalued bonds.
In the first of what is expected to be a wave of downgrades, Moody's has cut the rating of 131 subprime bonds because of higher-than-expected defaults. It is reviewing hundreds more. [...]
Subprime, says Mr Arbess, might well be "a dress rehearsal for something bigger and scarier."
The Collaterized Debt Obligation market (CDOs) has been understating risk and overstating price for some time now.
Amongst others, Bear Sterns would create a CDO in a bundle according to a client’s specifications. Indeed, Bear Sterns would work with a rating agency, such as Moody’s, to obtain the desired rating (a practice likely to face more scrutiny as some allege that Moody's no longer acts as an independent rating agency, but as a syndicator in the offering). The explosive demand in this sector has attracted ever more creative structures. Investors should have grown concerned when dealmakers started suggesting that one can create a higher grade security by grouping together a couple of lower grade securities; it is rare that 1+1 equals 3. As these instruments have grown more complex, the clients buying these instruments often do not have a full understanding of what they buy.
[...]
The risk to the financial system was not merely that some large brokerage firms may have been forced to write down a couple of hundred million dollars – they may still have to do that. But had the fire sale gone through, market values would have been available to the securities sold. This in turn would have forced other lenders to revalue the collateral they hold; and as the collateral is worth less, the brokers will lend less money. That would have triggered further margin calls, further forced liquidations. When hedge funds implode, they tend to sell off more liquid assets first; at the end of the sale, the prices of the liquid assets are depressed, yet the fund may still be left holding illiquid securities.
The most troubling element of this real estate bust is that there is little reason to believe that we've hit bottom yet. Most of the subprime and Alt-A borrowers (Alt-A's are one step up from subprime, and usually using an "exotic" mortgage to get into a house they may not be able to afford) used a "2/28". Which means 2 years at a low "teaser" interest rate, then their mortgage resets to a much higher market rate. Most of those 2/28's are about to reset.
Real Estate Bust in Hyperdrive
The inventory of unsold houses on the market hit a 15-year high today. This comes at the same time that the National Association of Realtors are predicting their first annual national decline in median housing prices in 40 years. This is happening at the same time that the home building industry is collapsing at its fastest rate in 32 years. 86 major mortgage lenders have gone bankrupt since late 2006. Rates on a 30-year mortgage just hit a 10-month high.
All this pain in the real estate market has led the Democratic Congress to propose taking away some of the Federal Reserve's regulatory power because it has failed to use it.
On the borrowers side, subprime households tend to not understand what they are getting into.
· Nearly nine out of 10 borrowers could not identify the correct amount of upfront charges connected with a loan.
· Four out of five had trouble understanding why the stated interest rate on the loan note was different from the annual percentage rate, or APR, highlighted in the truth-in-lending disclosure.
· Two-thirds did not spot a potentially dangerous snare lurking in the loan -- a substantial penalty if they refinanced within the first two years.
This was all very easy to predict. If you wanted to know where the real estate bust was going to be worst, all you needed was a map that I posted on DKos last year.
(things got even more crazy in Florida before it was over)
[Update]
For those who still think that the subprime meltdown is a "blip", I offer this article.
Bill Gross, manager of PIMCO, the world's largest bond fund, said on Tuesday the subprime mortgage crisis gripping U.S. financial markets was not an isolated event and will eventually take a toll on the economy.
"To death and taxes you can add this to your list of inevitabilities: the subprime crisis is not an isolated event and it won't be contained by a few days of headlines in The New York Times," he said.