Category: Credit Crisis

Deleveraging is the word of the year

Posted on by Evan in Credit, Credit Crisis

The Economist featured this great article today about the fact that not only financial firms but businesses and individual households will be forced to deleverage over the course of the next few years.

Among the points that I found interest in:

*In the near term delveraging of banks, hedge funds, and households will likely depress asset prices lower.  This is because as people sell assets to pay-off debt (deleverage) they will increase the supply of assets in the marketplace.

*Even if the bailout plan goes through the financial industry will likely suffer for sometime making credit harder to come by.

*Thanks to the impact of devleveraging, “a shortfall of bank capital of around $170 million may reduce the potential supply of credit by $1.7 trillion.”

*”Morgan Stanley reckons that total American debt (ie, the gross debt of households, companies and the government) has risen inexorably since 1980 to more than 300% of GDP (see chart), higher than it was in the Depression.”

Cost of bailout put in perspective

Posted on by Evan in Credit Crisis

Brett Arends wrote this terrific article for the WSJ.com analyzing the true cost of the $700 billion bailout.  Based on his analysis the true cost of the bailout is equal to, “one-third of 1% of our annual gross domestic product.”

I strongly believe we need to get this bailout done.  Here is a link to my rate update today where I also try to put the cost of the bailout in perspective.

In my view the costs of not doing the bailout far outweigh the cost of doing it.

#1 sign that bailout will work

Posted on by Evan in Credit Crisis

What is the #1 sign that the bailout will work?  How about this article in the WSJ which reports that Warren Buffett has reached an agreement with Goldman Sachs to buy $5 billion in preferred stock?

This give me confidence that this plan will make things right for our financial system.

Derivative market failure could lead to higher rates

Posted on by Evan in Credit Crisis, Economics & Interest Rates

MSN Money writer Jim Jubak wrote a great article today about the importance of the derivative market.  Little is known about derivatives outside of Wall Street but he makes a compelling case for government intervention because of the role that these financial instruments play in encouraging foreign investors to invest in US based financial securities.

Put simply, derivatives are insurance contracts that an investor can purchase from a “counter-party” which would require the counter-party to pay the investor a sum of money should a specific event occur.  For example, a sovereign wealth fund who was purchasing a large pool of US mortgage-backed bonds could purchase a derivative contract from a financial institution which would pay out a sum of money should defaults on mortgage increase past a certain level (say 5%).

These derivatives then act as hedges for the sovereign wealth fund should this pool of mortgages go bad.  In essence, they reduce the risk involved for foreign investors in making investments into an economy they may not be familiar with.

Without derivatives foreign investors who we rely on to buy up mortgage-backed bonds and other US financial securities would be far less likely to invest in the US.  Without their demand for our securities we would sit back and watch mortgage rates and other interest rates rise.

Rate Update September 22, 2008

Posted on by Evan in Credit Crisis, Rate Update

Rates are higher this morning.

The Fed & Treasury worked over the weekend on the government’s “bailout” plan for the financial industry. The bill is waiting congressional approval and is likely to allow the government to buy up to $700 billion in mortgage-backed securities from financial institutions.

Mortgage-backed bonds are suffering on the news because of inflationary concerns. In order for the government to pay for this plan they will have to print more money and that does not bode well for inflation.

There still exists a spread between 30-year treasury bonds and 30-year mortgage backed bonds which we continue to believe will converge (meaning mortgage rates will have to go down and/ or treasury bond yields will have to rise).

Current Outlook: near-term locking, long-term floating

Rate Update September 19, 2008

Posted on by Evan in Credit Crisis, Rate Update

Rates are unchanged from yesterday’s levels.

Mortgage rates do not know what to do after the government announced “bold” plans to shore up the financial system.  This announcement leaked yesterday afternoon which is why the stock market has rallied over the past 24 hours.

Treasury Secretary Henry Paulson announced this morning that the government would work over the weekend to create legislation designed to restore confidence in financial institutions.

The main points behind the program can be seen at this link.

At this point we are going to shift our outlook to neutral until we get more details about the plan.

Current Outlook: neutral

Main points of government intervention

Posted on by Evan in Credit Crisis

Treasury Secretary Henry Paulson made it public this morning (this news had leaked yesterday afternoon causing stocks to rally in late trading) that the government would intervene in the financial markets to shore up confidence in the financial system.

According the Wall Street Journal the government’s intervention could become “the largest intervention in the financial markets since the 1930s.”  This is great news as the health of the financial system was being called into question over the past couple days.

In fact, over the past two days $180 billion has been taken out of traditionally safe money market funds because of fear that the assets backing the fund would fall below the value of the deposits.  This led to investors buying short-term treasury securities with a NEGATIVE RETURN (meaning these investors were willing to accept less money than the money they were investing for the safety of the US government).

Among the measures that the Treasury Secretary announced this morning were-

*Increase the government’s purchases of mortgage backed securities.

*Acquire “bad assets” (risky mortgage-backed bonds) from financial institutions so they can remove them form their balance sheet.

*Ban investors from “short-selling” the stocks of 799 vulnerable financial institutions.

It is unclear what this new intervention will look like in terms of the organizational structure but more details should become available early next week.

Short-term treasuries move to negative return

Posted on by Evan in Credit Crisis, Economics & Interest Rates

In probably the most telling sign that the financial markets are a mess yields on short-term treasuries actually turned negative yesterday.  WSJ.com reported on this phenomenon in this article.

* “The desperation was especially striking in the market for U.S. government debt, long considered the safest of investments. At one point during the day, investors were willing to pay more for one-month Treasurys than they could expect to get back when the bonds matured. Some investors, in essence, had decided that a small but known loss was better than the uncertainty connected to any other type of investment.

That’s never happened before. In a special government auction on Wednesday, demand ran so high that the Treasury Department sold $40 billion in bills, far beyond what it needed to cover the government’s obligations.”

WSJ.com-Worst crisis since Great Depression

Posted on by Evan in Credit Crisis, Economics & Interest Rates, Housing & Real Estate

WSJ.com featured a great article summarizing the problems we find ourselves in.  You may access the article by clicking this link.

Among the points that I found interesting-

* “This has been the worst financial crisis since the Great Depression. There is no question about it,” said Mark Gertler, a New York University economist who worked with fellow academic Ben Bernanke, now the Federal Reserve chairman, to explain how financial turmoil can infect the overall economy. “But at the same time we have the policy mechanisms in place fighting it, which is something we didn’t have during the Great Depression.”

* Fed and Treasury officials have identified the disease. It’s called deleveraging, or the unwinding of debt. During the credit boom, financial institutions and American households took on too much debt. Between 2002 and 2006, household borrowing grew at an average annual rate of 11%, far outpacing overall economic growth. Borrowing by financial institutions grew by a 10% annualized rate. Now many of those borrowers can’t pay back the loans, a problem that is exacerbated by the collapse in housing prices. They need to reduce their dependence on borrowed money, a painful and drawn-out process that can choke off credit and economic growth.

* At least three things need to happen to bring the deleveraging process to an end, and they’re hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets.

* Today, Mr. Bernanke is taking out his playbook, said NYU economist Mr. Gertler, “and rewriting it as we go.”

* The latest trouble spot is an area called credit-default swaps, which are private contracts that let firms trade bets on whether a borrower is going to default. When a default occurs, one party pays off the other. The value of the swaps rise and fall as the market reassesses the risk that a company won’t be able to honor its obligations. Firms use these instruments both as insurance — to hedge their exposures to risk — and to wager on the health of other companies. There are now credit-default swaps on more than $62 trillion in debt, up from about $144 billion a decade ago.

Kudos to Barron’s part II

Posted on by Evan in Credit Crisis, Economics & Interest Rates, General Mortgage Info., Housing & Real Estate

After reading and blogging about one article in Barron’s this weekend I came to another outstading one.  Here is a link.  Nice work Barron’s.

Among the points that I found interesting:

* If Fannie Mae [ticker: FNM] and Freddie Mac [FRE] stopped all of their activity — for a moment, forget about shutting them down and being insolvent — in order to sell off mortgages as normal loans without this guarantee, the interest rate would have to be around 9% or 10%.

* Q: What other negatives do you see?

A: Inflation risk down the line. [The federal government is] going to probably overstimulate and over support in an attempt to stem these deflationary forces. We are looking at a longer-term inflationary force that is pretty substantial. This has been my view for a long time. Interest rates went into a very long decline from the late ’70s and early ’80s until earlier this decade, when first we saw rates bottom out. Then rates went up a couple of times.

Basically, we are getting back down toward those low levels again. The multiyear bottom in interest rates that started around 2002 will probably last into 2009. Then we are going to see the inflationary aftermath of these government policies, and you might be surprised at how high interest rates go.

* Q: How much more pain are we going to feel in the housing market before things start to stabilize?

A: I think we are about half way through. There is high momentum in terms of home-price declines, so it is pretty clear they are going lower. It always looks a lot like the hills on a roller coaster. It starts out with a flattish period. Then it starts to go down, and then it really starts to drop, and we are clearly in that period. That period is going to be with us for about another year before it flattens out and bumps along in 2010.

The S&P/Case-Shiller Index is down a little more than 15% from its peak in 2006, and I’ve believed for some time that the index will have dropped 30% from its peak. That means some markets are going to drop by 50%. That includes Miami, Las Vegas and Phoenix, all of which were fueled by subprime lending. The foreclosure overhang is so big in those areas.