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Sunday, September 16, 2007

The Second Event

Update: Bloomberg reports overnight LIBOR way up:
The overnight rate banks charge to lend pounds soared 60 basis points to 6.47 percent today, the highest in more than a month, according to the British Bankers' Association. The three- month rate fell 7 basis points to 6.75 percent, the BBA said.
End update.

Northern Rock's collapse in the UK is almost certainly the second event. It is significant for several reasons. The first is that the UK economic growth has been funded in recent years similarly to growth in the US, i.e., high debt and high immigration, combined with stagnating wages for a large cohort of the native population. The second is that in recent years high risk terms on those mortgages that have spawned housing appreciation have been very common. The problem with Northern Rock was not that it securitized mortgages, but that it wrote risky mortgages for lower rates than the market is now willing to absorb. But it is not the only UK bank to do so, merely the most aggressive.

The danger that non-stakeholder immigration poses to an economy is universal. See this 2005 Bear Sterns commentary on the illegal American workers. The study discusses the problem of miscalculating the cost of public services, but ignores another fundamental: non-stakeholder immigration (any immigration which causes the immigrants to be excluded as a class from full rights in the society, whether by legal means or by sub rosa means) inflates some assets, notably rental housing, short-term, but lowers the overall capacity of the population to consume long-term, which eventually causes a cycle of deflation. The problem with immigration in Europe is nearly universal; generally high taxation rates prevent even legal immigrants from accumulating capital.

Compared to the US, most European areas which have experienced high rates of housing inflation have less real basis and more real risk. There has been huge speculation in European housing markets as well. Spain was the first to fall, but the retrenchment in the UK in all areas which have not seen the income booms of the London sector will be punishing. Bankruptcies and foreclosures in the UK are rising and will continue to rise for some time.

The impact on Europe, then, will be more general. Europe has been, for the most part, comfortably enjoying the theory that it is risk in American securitizations which is the problem. Northern Rock had nothing to do with American mortgages; its problems and its stability are entirely due to its own unsustainable mortgages, which are not unique to the UK. Another barrier of plausible deniability has been torn, and the consequences will be far-reaching.

In addition there is an internal carry trade in Europe which has funded many of the emerging mortgage markets:
The chart (below) shows the relationship between the euro and the hitherto “safe” Swiss Franc. So widespread has the carry trade phenomenon become that fully 92% of Hungarian home equity loans and around 70% of Polish housing debt are denominated in Swiss Francs.

The article blabs on about safe havens and the like, but the reason that the yen and the Swiss franc yielded lower interest was that these economies had surpluses of money and not enough places to invest it internally. The cost of money is dominated by the supply/demand equation just as the cost of everything else. The Swiss take money in from rich interests in unstable countries as a safe haven, serving as the bankers, I am sure, for most of the more than 10,000 member Saudi Arabian royal family, not to mention all those who are temporarily at the top of the heap in the unstable societies around the world. (I often wonder how many of the Boeing orders for smaller jets derive from the same source; money in Switzerland and a fueled jet ready to whisk you out of the country within hours' notice are the fundamentals of financial planning for many of these individuals.) Then the Swiss banker has to find a place to put that money, and in recent years a lot of it has been lent to banks which are lending it to other banks, which lend it to other banks, who eventually lend it to the bubble areas for investment in property.

The history of the 1920's has repeated itself with a twist; wheat is now very expensive, but it is the Hungarian and Polish mortgages which are likely to default. The situation is not as severe as it was then, but it is similar in the effect it will probably have on the European banking system - an unwinding that travels through the long chain of lending to bring risk back to its source. There is also a lot of unstable commercial debt out there, some of which has been used to fund acquisitions and investments in the ex-Soviet bloc.

Most of the big financial firms are still forecasting an economic decoupling of the world with the US. I may be wrong, but I believe all of these forecasts are delusional in the extreme. The same problems that are causing drawbacks in the US economy exist globally. The Japanese economy is weakening; European growth has been lacking by US standards and is likely to continue to decline, and worldwide inflation is on the rise, having a fierce impact upon the living standards of the emerging Asian nations.

It cannot be coincidence that Chinese and Indian interests are trying to invest money in the US even while their own economies are booming. In China one would expect the motive to be fear of the government and the peasantry; in India one would expect the motive to be fear of a crashing bubble.

In the meantime, it's worth a note that the Germans have had to slaughter poultry by the thousands this year. H5N1 is widespread in some German districts among wildfowl and is infecting poultry farms.

Interesting article in the new Economist asserts that bubbles in many Euro countries are worse than in the US.
The history of the 1920's has repeated itself with a twist...

I offer another similarity between the 1920's and the present.

Edifice Complex
David - the article is correct. Mark, that's an interesting thesis. Maybe companies do that when they get complacent?

Maybe companies do that when they get complacent?

Yeah, I think you might be right. I certainly don't think the place where I worked saw the problems coming, but the problems most certainly came.

Walter Forbes goes down
At marriage time CUC appeared to be pristinely profitable. But when the merged companies attempted to combine their accounts in early 1998, CUC's financial statements couldn't stand close inspection and the company was suddenly exposed as having cooked its books for years. On the news, Cendant's market value dropped by about $14 billion in one day.
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