subprime market woes leading to recession?

[Ancalagon]

I'm going to link to a wikipedia article here insead of a news story, but feel free to add stuff.

In short, the market has been suffering because a lot of morgages are up for renewal in 2007 (one TRILLION's worth of dollars) and the interest rate are much higher than in 2002. As a result, a lot are defaulting, especialy in the subprime loan area. Too many defaults lead to too many home sales, house values fall, people have negative equity and it's all bad mkay?

http://en.wikipedia.org/wiki/Subprime_mortgage_financial_crisis

[TiQuinn]

I think the problem is somewhat overstated and that this is a very healthy pullback. Healthy, unfortunately, means that not everyone is going to come out of this happy, because many people have taken incredible risks despite several warnings about subprime loans, and it's finally coming home to roost. I think it's overstated because there's an assumption that everyone who took out a home equity loan has spent all of that money, and are now sitting on a pile of debt. Further, is it really so bad that people who have overextended themselves have to face reality? Does society REALLY want to continually prop up people who are making bad financial decisions? I think this is a choice between taking your medicine now or having to deal with a even worse illness later on.

[Limper]

It needed to happen but would have better if they hadn't hamfisted the effort. Spectulators are the ones getting burned hard.

[Janos]

Great Article from Stratfor on the size and impact of the crisis on a local and national level:

The subprime crisis is worth analysis in its own right, though it also gives us the opportunity to discuss our own approach to economic issues. Stratfor views the world through the prism of geopolitics. In geopolitics, there is no such thing as separating a country's economy from its national security or its political interests. A nation is a nation. Academic departments divide themselves nicely into areas of study. In the real world, things are much too intertwined and sloppy for that. Geopolitics views the international system and nations as consisting of a single fabric of relationships, with economics being one of the elements.

Not all events have geopolitical significance. To rise to a level of significance, an event -- economic, political or military -- must result in a decisive change in the international system, or at least a fundamental change in the behavior of a nation. The Japanese banking crisis of the early 1990s was a geopolitically significant event. Japan, the second-largest economy in the world, changed its behavior in important ways, leaving room for another power -- China -- to move into the niche Japan had previously owned as the world's export dynamo. The dot-com meltdown was not geopolitically significant. The U.S. economy had been expanding for about nine years -- a remarkably long time -- and was due for a recession. Inefficiencies had become rampant in the system, nowhere more so than in the dot-com bubble. The sector was demolished and life went on. Lives might have been shattered, but geopolitics is unsentimental about such matters.

The Russian default of 1998 was a geopolitically significant event. It marked the end of the post-Cold War period and the beginning of the new geopolitical regime that is increasingly showing itself in Russia. The global depression of the 1920s and 1930s was enormously significant, transforming the internal political and social processes of countries such as the United States and Germany, and setting the stage for political and military processes that transformed the world. The savings and loan (S&L) crisis of the 1980s had no real geopolitical effect, and the collapse of Enron meant nothing. However, the consolidation of Russian natural gas exports under Gazprom's control is certainly a major change.

The measure of geopolitical significance is whether an event changes the global balance of power or the behavior of a major international power. Looking at the subprime crisis from a geopolitical perspective, this is the fundamental question. That a great many people are losing a great deal of money is obvious. Whether this matters in the long run -- which is what geopolitics is all about -- is another matter entirely.

The origins of the crisis seem fairly clear. Traditionally, when banks look at mortgages on homes, they carefully study the likelihood that the loan will be repaid, as well as the underlying collateral. Their revenue and profits come from the repayment of the loan or the ability to realize the value of the loan through the forced sale of the house.

Two things changed this simple model. The first started a long time ago. Encouraged by the federal government, banks that issued mortgage loans began selling those loans to other entities. This, then, created a large secondary market in bundled mortgages -- huge numbers of mortgages grouped together and sold and traded as if they were simply financial instruments, which, of course, they are.

As a result, banks began to view mortgages less as long-term investments than as transactions. They made their money on closing costs, rapidly selling the mortgages to aggregators, which in turn passed them on to others. The banks then loaned the money again. The more mortgages banks racked up, the more money they made. The risk was transferred to others.

In the past few years, two new groups of players entered the scene, one on either end of the spectrum. The first group comprised mortgage companies and brokers, nonbanking institutions whose business model was built primarily around the transaction. The brokers in particular had no skin in the game. Every time they executed a mortgage, they made money. If they didn't execute one, they didn't make money. The role of evaluating the borrower increasingly fell to these entities, neither of which was going to hold on to the debt instrument for more than a moment.

The second group was the final buyers of bundled mortgages -- increasingly, hedge funds. Hedge funds are monies gathered from various "qualified" investors -- otherwise known as rich people and institutions. They are private partnerships, so what they do with their money is between the managers and partners. No federal agency is responsible for protecting the private placement of money by the wealthy.

In a world of relatively low interest rates, wealth-seeking investors flocked to these hedge funds. Some of the older ones were superbly managed. The newer ones frequently were not. With a great deal of money in the system, there was a restless search for things to invest in -- and the secondary market in subprime mortgages appeared to be extremely attractive. Carrying relatively high rates of return, and theoretically collateralized by fairly liquid private homes, the risks of these deals appeared low and the returns on the mortgages -- particularly when you looked at the contracted increases -- seemed extremely attractive.

The fact is that no one really worried about defaults. The mortgage originators that prepared the documentation for these riskier loans certainly didn't care. They just wanted the mortgages to go through. The primary lenders didn't worry because they were going to resell them in hours or days anyway. The mortgage aggregators didn't care because they were going to resell them, too. And the final holders didn't worry because they assumed the system would permit easy refinancing of loans at sustainable interest rates, and that -- in a worst-case scenario -- they at least owned a portfolio of houses that they could bundle and sell to real estate companies, perhaps even at a profit.

The final owner of the mortgage, of course, is the loser. The assumption that subprimes could be refinanced if need be failed to take into account that higher interest rates priced these people out of the market. But the worst part is this: Many hedge funds leveraged their purchase of mortgages by using them as collateral to borrow money from the banks.

That was the tipping point. When the subprime defaults started to hit, the banks that had loaned money against the mortgage portfolios re-evaluated the loans. They called some, they stopped rollovers of others and they raised interest rates. Basically, the banks started reducing the valuation of the underlying assets -- subprime mortgages -- and the internal financial positions of some hedge funds started to unravel. In some cases, the hedge funds could not repay the loans because they were unable to resell their subprime mortgages. This started causing a liquidity crisis in the global banking system, and the U.S. Federal Reserve and the European Central Bank began pumping money into the system.

Told this way, this is a story of how excess emerges in a business cycle. But it is not really a very interesting story because the business cycle always ends in excess. As economic conditions improve, more people with more money chase fewer investment opportunities. They crowd into investments that seem to guarantee vast or sure returns -- and they get hammered. The economy contracts into a recession, as it tends to do twice every decade, and then life goes on.

There currently are three possibilities. One is that the subprime crisis is an overblown event that will not even represent the culmination of a business cycle. The second is that we are about to enter a normal cyclical recession. The third, and the one that interests us, is that this crisis could result in a fundamental shift in how the U.S. or the international system works.

We need to benchmark the subprime crisis against other economic crises, and the one that most readily comes to mind is the savings and loan crisis of the 1980s. The two are not identical, but each involved careless lending practices that affected the economy while devastating individuals. But looking at it in a geopolitical sense, the S&L crisis was a nonevent. It affected nothing. Bearing in mind the difficulty of quantifying such things because of definitions, let's look for an order of magnitude comparison to see whether the subprime crisis is smaller or larger than the S&L crisis before it.

Not knowing the size of the ultimate loss after workout, we try to measure the magnitude of the problem from the size of the asset class at risk. But we work from the assumption that proved true in the S&L crisis: Financial instruments collateralized against real estate, in the long run, limit losses dramatically, although the impact on individual investors and homeowners can be devastating. We have no idea of the final workout numbers on subprime. That will depend on the final total of defaults, the ability to refinance, the ability to sell the houses and the price received. The final rectification of the subprime will be a small fraction of the total size of the pool.

Therefore, we look at the size of the at-risk pool, compared to the size of the economy as a whole, to get a sense of the order of magnitude we are dealing with. In looking at the assets involved and comparing them to the gross domestic product (GDP), the overall size of the economy, the Federal Deposit Insurance Corp. estimates that the total amount of assets involved in that crisis was $519 billion. Note that these are assets in the at-risk class, not failed loans. The size of the economy from 1986 to 1989 (the period of greatest turmoil) was between $4.5 trillion and $5.5 trillion. So the S&L crisis involved assets of between 8 percent and 10 percent of GDP. The final losses incurred amounted to about 3 percent of GDP, incurred over time.

The size of the total subprime market is estimated by Reuters to be about $500 billion. Again, this is the total asset pool, not nonperforming loans. The GDP of the United States today is about $14 trillion. That means this crisis represents about 3.5 percent of GDP, compared to between 9 percent and 10 percent of GDP in the S&L crisis. If history repeats itself -- which it won't precisely -- for the subprime crisis to equal the S&L crisis, the entire asset base would have to be written off, and that is unlikely. That would require a collapse in the private home market substantially greater than the collapse in the commercial real estate market in the 1980s -- and that was quite a terrific collapse.

Now, many arguments could be made that the estimates here are faulty or that different concepts should be used. We will concede that there are several ways of looking at this crisis. But in trying to get a handle on it strictly from a geopolitical perspective, this gives us a benchmark with which to analyze the mess.

Can it balloon into something greater? The big risk is that the weak hands in the game, the hedge funds, are suddenly coming into possession of a great number of houses that they will have to put on the market simultaneously in fire sales. That could force home prices down. At the same time, most homes are not at risk, and their owners are not hedge funds. Moreover, it is not clear whether most of the hedge funds that own subprime mortgages will be forced to try to monetize the underlying assets. It is far from clear whether the crisis will affect home prices decisively. If home prices were to collapse at the rate that commercial real estate collapsed in the 1980s, we would revisit the issue. But, unlike commercial real estate, in which price declines force more properties on the market, home real estate has the opposite tendency when prices decline -- inventory contracts. So, unless this crisis can pyramid to forced sales in excess of the subprime market, we do not see this rising to geopolitical significance.

From this, two conclusions emerge: First, this is far from being a geopolitically significant event. Second, it is not clear whether this is large enough to represent the culminating event in this business cycle. It could advance to that, but it is not there yet. We cannot preclude the possibility, though it seems more likely to be a stress point in an ongoing business cycle.

Apart from discussing the subprime issue, this crisis offers us an opportunity to explain how we view economic activity. First, we try to understand, at a fairly high level, what exactly happened, much as we would approach a war or a coup. Then we try to compare this event to other events whose outcomes we know. And, finally, we try to place it on a continuum ranging from fundamental geopolitical change to normal background noise. This is more than normal background noise, but it has not yet risen even to the level of a routine, cyclical shift in the business cycle.

[Limper]

Awsome article.

[Ancalagon]

about one trillion dollars of mortgages are due in 2007, and there are a lot of defaulting in the non-subprime one.

The carry trade is starting to be affected, and that's worysome too. the following article isn't about that per say, but it has an interesting bit in it...

http://www.cbc.ca/money/story/2007/08/15/dollar-markets.html

highlights

The Canadian dollar fell by almost a full cent Wednesday — one day fter taking its biggest hit in more than a year — as alarm bells rang in previously obscure corners of the world's credit markets.

Amid a growing aversion to risk, "there is an absolutely massive unwinding of something that is called the yen carry trade right now," she said.

"What that means essentially is that investors who borrowed cheap money in Japan to invest in various countries, including Canada, are now reversing that trade. They are selling their Canadian assets, they are selling their loonies, in absolutely massive amounts, and that has caused the loonie to tumble."

[Morbidity]

It needed to happen but would have better if they hadn't hamfisted the effort. Spectulators are the ones getting burned hard.

Speculators are being burned hard but anyone in the market is being burned.

Excellent article Janos.

It's really the combination of hedge funds investing in the securitised sub-prime mortgage market and the leveraged nature of hedge funds that's the problem. Basically the impact of the sub-prime mortgages means that hedge funds had to de-leverage, which involved selling off equities which have absolutely nothing to do with the sub-prime market. The sudden influx of these equities reduces their price and so on.

Another good article here from the Times.

Hedge funds forced into equities fire sale
Christine Seib
Goldman Sachs has made the announcement that everyone has been waiting for. The investment bank admitted yesterday that three of its high-profile hedge funds had off-loaded massive equity holdings following days of stock market turbulence.

In recent days, whispers at rival fund managers had blamed a fire sale at Goldman Sachs for the devastating downward spiral afflicting global financial markets. The truth is that the bank was not alone. Almost every big quantitative fund using a strategy similar to Goldman’s – known as an equity market neutral (EMN) strategy – was suffering in its own way.

The result has been a rout of one of the most popular types of quant fund. Hedge Fund Research’s EMN index had lost 7.6 per cent by last Thursday and undoubtedly saw further points shaved off during Friday’s plunge in equities.

EMN funds make their money by identifying investment opportunities in a specific group of stocks, while neutralising their exposure to the sector. They do this by taking long positions on shares that they expect to out-perform the sector and short positions on those that they expect to underperform.

The managers of the EMN quant funds set the criteria for the share purchases, based on elements such as price/earnings ratios. Once the parameters are set, sophisticated computer programs take over the business of trading. Until last week, City wisdom held that the funds were incapable of producing heavy losses.

One leading fund of hedge funds manager expects EMN’s difficulties to hit the reputation of quant funds as a safe harbour for investors. “Previously they had a reputation of being good protection because they couldn’t make a loss,” the fund manager said. “People know now that that’s not true”.

But experts do not expect the long-awaited hedge fund blow-up to come from the quants. John Godden, chief executive of IGS Group, the hedge fund consultancy, said: “The funds will endure short-term pain but you’re not going to get a meltdown of asset values because they remain in the liquid end of the spectrum. It’s the derivative-linked stuff where you can see the possibility of the values hitting zero.”

Equity quant funds have made strong, stable returns over the past few years, which has attracted the interest of large multi-strategy hedge funds. Big players such as Tykhe Capital, Goldman Sachs and Renaissance Technology have been allocating growing sums to EMN, with increasingly ambitious leveraging. According to Hedge Fund Research, investors pumped an additional $2 billion into ECM funds in the second quarter, taking the total amount invested to $40.7 billion.

In recent weeks, prime brokers have begun to make margin calls – asking their hedge fund clients to put up greater collateral in order to secure their credit lines. To cover their margin calls, the funds were forced to sell some equity assets. Most had invested in the same stocks, concentrating on value investments.

Jerome Berset, an analyst for Capital Management Advisors, the fund of hedge funds, said: “As those big players with huge leverage started to unwind their positions, covering shorts and selling longs, short names started to rally and longs started to fall and it started to hit the market.”

Once the market started to fall, hedge fund managers were pushed to sell more and more equities, at ever-decreasing prices, in order to obtain the cash they required. “Once one guy starts deleveraging, they all have to, and they try to do it more quickly than their neighbours,” a fund of funds manager said.

[Ancalagon]

very interesting! A lot of this stuff is very obscure, and the more articles like this the clearer the picture gets.

Ancalagon

[Ancalagon]

the commercial paper market is starting to be affected - another form of lack of credit. I'm not too sure how this fits in the larger picture or how "big" it is.

edit: I also am disagreeing with statford because they missed one element - china is threatening the USA via the US dollar. I believe that this is quite significant on a geopolitical level.

[Janos]

the commercial paper market is starting to be affected - another form of lack of credit. I'm not too sure how this fits in the larger picture or how "big" it is.

If you mean Newspapers, they've been losing money for years. They're just getting headlines now because the merger phase has started.

edit: I also am disagreeing with statford because they missed one element - china is threatening the USA via the US dollar. I believe that this is quite significant on a geopolitical level.

But that's an issue in itself not related to the Subprime market.

[Ancalagon]

If you mean Newspapers, they've been losing money for years. They're just getting headlines now because the merger phase has started.

No, it's something I didn't even know existed until recently:

http://en.wikipedia.org/wiki/Commercial_paper

"Commercial paper is a money market security issued by large banks and corporations. It is generally not used to finance long-term investments but rather for purchases of inventory or to manage working capital. It is commonly bought by money funds (the issuing amounts are often too high for individual investors), and is generally regarded as a very safe investment. As a relatively low risk option, commercial paper returns are not large. There are four basic kinds of commercial paper: promissory notes, drafts, checks, and certificates of deposit.

Because commercial paper maturities don't exceed nine months and proceeds typically are used only for current transactions, the notes are exempt from registration as securities with the United States Securities and Exchange Commission."

But that's an issue in itself not related to the Subprime market.

true - but the weakness created by the current crisis is giving their threat extra weight.

[mollygrue]

all well and good gentlemen--but as we discuss these matters of high finance--and i know some of you are indeed well qualified to discourse on the subject--may we also pause to consider the very human impact that all this is having on real familys, real lives? there are quite a number of folks that ive talked to lately who were persuaded to overextend themselves--often with a poor understanding of what they were actually getting into--and while it translates into charts and graphs, trends and observations for the investors--what about the impact it is having on PEOPLE?

[Ancalagon]

all well and good gentlemen--but as we discuss these matters of high finance--and i know some of you are indeed well qualified to discourse on the subject--may we also pause to consider the very human impact that all this is having on real familys, real lives? there are quite a number of folks that ive talked to lately who were persuaded to overextend themselves--often with a poor understanding of what they were actually getting into--and while it translates into charts and graphs, trends and observations for the investors--what about the impact it is having on PEOPLE?

well this is why this matters.

People, because of foolishness, lack of education or predatory loaning practices, have taken loans they should not have and are hurting a lot. And people who are more prudent - well their mutual funds they build for their retirement are being kicked in the nuts, so they are suffering too.

I don't care about some great tycoon loosing billions of dollars. But I do care about the people suffering, or the 2000 employees he's going to fire (yet another form of serious financial woe).

We all know a bit about suffering I think (some more than others), so I guess that's why we aren't mentioning it... it's like a given. But I want to talk about these arcane financial matters so that we understand why a ton of bricks is falling on our heads.

Ancalagon

[Janos]

there are quite a number of folks that ive talked to lately who were persuaded to overextend themselves--often with a poor understanding of what they were actually getting into?

Personally, I'm not real happy with them. I've lost some money on investments because of their decisions. I don't think they should end up totally screwed, but I'm in favor of a larger degree of personal responsibility being taken by those screaming "the lenders duped us!" Basically I'm not a big fan of a bail-out plan. I'd be ok with annulling some debt or otherwise equalizing things so that they aren't going to be paying for this mistake for decades to come, but I have almost no sympathy regarding their investment in their houses and the like.

I'm not real happy with lenders and hedge funds either, and I think they need to have some major restrictions put in place on this sort of thing. But ultimately those taken in share the largest piece of responsibility in my mind. Overspending with clever money games is far too common, and far too accepted a practice these days.

People who buy from spammers propagate spam. People who borrow what they know they can't pay are just as guilty.

[Ancalagon]

Some really good articles from the economist.

some of you may remember that in 2005 I posted an article by the economist postulating the existence of a bubble in the housing market... so I tend to give their articles a fair bit of weight

http://www.economist.com/finance/displaystory.cfm?story_id=9659733
http://www.economist.com/finance/displaystory.cfm?story_id=9660039

One of the highlight is how banks are growing distrustful of each other and not very willing to lend to one another. Another is how the "distributed risk" model makes it very hard for people to figure out exactly how much has been lost and by whom.

Ancalagon

[TiQuinn]

all well and good gentlemen--but as we discuss these matters of high finance--and i know some of you are indeed well qualified to discourse on the subject--may we also pause to consider the very human impact that all this is having on real familys, real lives? there are quite a number of folks that ive talked to lately who were persuaded to overextend themselves--often with a poor understanding of what they were actually getting into--and while it translates into charts and graphs, trends and observations for the investors--what about the impact it is having on PEOPLE?

We can't help the people who didn't understand what they got into. They really need to suffer through that one, I think. But this is why I also think that sometimes a hard landing in the economy is better than a soft landing. If we were to see people demand and Congress enact a law banning predatory lending, you would see the market take a nosedive. Many people would say that's a bad thing, and we're putting many more people out of work if that happened, and so on, but I don't see it quite that way. If there's a cancer in the system, it shouldn't be allowed to exist just because we'd suffer pain in the meantime. The end result would be better lending practices across the board. The flip side will also be that the people who don't deserve credit or home loans wouldn't get them either, and I think that group would be quite large.