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Friday, November 30, 2007

Pigs Fly, Hell Freezes Over

Or maybe that should be something about frying pans and fires.

The sorrowful tale of soaring inflation in the Eurozone:
European inflation accelerated in November to the fastest in more than six years, adding pressure on the European Central Bank to raise interest rates even as economic expansion cools.

The inflation rate in the 13-nation euro area rose to 3 percent this month from 2.6 percent in October, the European Union's statistics office in Luxembourg said today. An index of executive and consumer sentiment fell to a 20-month low of 104.8 from 106 in October, according to a separate report.

A 75 percent surge in oil prices since mid-January and rising food prices are driving inflation further above the ECB's 2 percent ceiling.
Hmm. Sounds just like the US, doesn't it. However this sorrowful tale takes place against a backdrop of agonized calls for rate cuts:
A clutch of Europe's top economists have called on the European Central Bank to cut interest rates at its policy meeting next week, warning of severe downturn unless confidence is restored quickly to the banking system.

The concerns came as one-month Euribor spiked violently by 60 basis points to 4.87pc today, the sharpest move ever recorded. Italy's financial daily Il Sole splashed on its website that the Euribor had "gone mad".
Thomas Mayer, Europe economist for Deutsche Bank, said the authorities should take pre-emptive action to unfreeze the debt markets and reduce the danger that events could spiral out of control.

"If they don't do anything, this could go beyond just a normal recession. With this credit crisis it could turn into a very uncomfortable situation, with a real economy-wide crunch that we cannot stop," he said.
Pigs just flew and hell just froze over. A German banker is advocating ignoring inflation and pumping money into the economy. The last paragraph is the way a German banker describes depression without speaking the word, which must, of course, not be spoken.

Needless to say, the ECB is between a rock and a hard place. Whatever they do will cause pain. Mervyn, the King of BofE, has been making worried noises as well, while one of his colleagues, Blanchflower, is fueling up the Royal Helicopters. Interbank lending is breaking down, and something has to be done to stop that.

Meanwhile, back at the ranch, Americans are being treated to the Fed's "Fed be nimble, Fed be quick" dramatic puppet show. For some time it's been working this way: Periodically one of the Fed governors draws the little slip that says "You are the Inflation Hawk for this month". That guv gets to put on the Red and Yellow cape with the mask of the falcon and soar around speaking engagements announcing the Fed's inalterable determination to quash inflation forever, or at least for our time. But other guvs draw the slips that say "Money dropping helicopters standing by", and thus are assigned to don the pilot's goggles and carry a big bag with a dollar sign on it over their backs, while making kindly appearances at banquets like some Wall Street version of St. Nick. No reindeer, but instead they dandle investors on their knees and explain that the Fed has a veritable army of deflation-fighting money dropping choppers in the waiting.

Guess who drew which assignment. Bernanke:
Economic forecasting is always difficult, but the current stresses in financial markets make the uncertainty surrounding the outlook even greater than usual. We at the Federal Reserve will have to remain exceptionally alert and flexible as we continue to assess how best to promote sustainable economic growth and price stability in the United States.
To be sure, lowering interest rates to keep the economy on an even keel when adverse financial market developments occur will reduce the penalty incurred by some people who exercised poor judgment. But these people are still bearing the costs of their decisions and we should not hold the economy hostage to teach a small segment of the population a lesson.
As the Federal Open Market Committee noted at its last meeting, uncertainties about the economic outlook are unusually high right now. In my view, these uncertainties require flexible and pragmatic policymaking--nimble is the adjective I used a few weeks ago. In the conduct of monetary policy, as Chairman Bernanke has emphasized, we will act as needed to foster both price stability and full employment.
As I discussed in a speech in early November, the heightened uncertainty flows from an increase in risk, which can be broken down into two components: valuation risk, which arises when the market realizes that the complexity of a security or the opaqueness of its underlying creditworthiness prevents it from accurately assessing the value of the security; and macroeconomic risk--that is, the risk that a financial disruption will cause significant deterioration in the real economy, which can, in turn, worsen the financial disruption (Mishkin, 2007d). The Federal Reserve's recent policy actions are intended to help lower macroeconomic risk and thereby improve the functioning of financial markets. In addition, our enhanced communications will help reduce macroeconomic risk by providing additional information regarding our policy strategy and our assessment of the economic outlook.
I'm almost sure that Mishkin is saying in this speech that the Fed is counting on controlling inflation by telling us very firmly that it will do so, which is supposed to control expectations.

The last appearance of the Fed Inflation Hawk occurred on November 16th when Kroszner spoke:
Looking forward, one feature of monetary policy to keep in mind is that, all else equal, each successive action in the same direction tends to lower the incremental benefits and to raise the incremental costs of additional actions. For example, unless underlying economic conditions or risks change substantially, reductions in the target federal funds rate tend to be associated with decreasing incremental benefits in terms of further mitigating tail risks and with increasing incremental costs in terms of the potential for inflation to increase. In the current context, I would be especially concerned if inflation expectations were to become unmoored and will watch both market-based and survey-based measures of inflation expectations closely.
The Hawk appears to be hooded at this time.

There is no alternative to continuing to pump enough gas into to keep the financial engines at least sputtering along, because the alternative is deflation and the approach to depression. The decoupling hypothesis has died an ignominious death, and we are slowly realizing that we are all in this together. You can't control commodity inflation (metals, fuel and food) without reducing demand, but you can't afford to let demand fall very much during a credit crunch. The credit crunch takes over if you do.

The only real way to control inflation at all while avoiding a severe recession or depression when so much of the globe has been playing the easy credit game, is to creatively destroy existing debt while infusing enough liquidity into the system to make it profitable to make new loans. This is a tricky tightrope to walk, and my guess is that the Central Banks are practicing to take this joint show on the tightrope. The increasing calls from the Treasury for debt writedowns are an implicit promise to bankers that if they accept the destruction of their value involved in cutting debts and/or interest rates, the better among them will be permitted to drink deep of the wells of government money. Or perhaps even the worst.

We'll see. The question in my mind is whether the Fed realizes how far they will have to go. The problem that shows up in my calculations is that the housing bubble created by easy underwriting is going to cause epic losses in Alt-A debt because of geographic correlations. The spec loans will all crash within two years. They can be written off now (or could be if anyone had bothered to figure out which of these were spec loans at underwriting). Prime, Alt-A or subprime doesn't matter for spec loans.

If the remaining bad loans were just subprime, compensating with low rates would be easier. The relatively high interest rates for subprime actually give a lot of negotiation room while still in theory maintaining a decent NIM with much lower primary borrowing rates. But the very low teaser rates and face rates involved in many of the recent Alt-A vintages leave almost no room for negotiation unless prime is cut to around 2.00%. Does the Fed intend to go that low? Does it realize that it will have to? And how will we pay the servicers? It costs a lot to do your underwriting just before expected default.

If these loans were not securitized it would be much easier to maximize the flow on the whole pool. But when you have interest tranches, and equity tranches, and tranches in theory protected from major losses to the pool as a whole, it's a different story. No one has yet answered the question of how the servicers get paid and get legal cover.

Countrywide's brilliant theory of refinancing all of its loans for free through Fannie is going to come to an end, because Fannie is tightening in December and March, and Fannie is running out of money anyway.

Now the Baton of Bad Loans gets passed to the regional banks as the commercial portfolios go bad. After that, a cohort of much smaller institutions get sentenced to Death by Home Equity.


Great post. I think another thing the Fed overlooks is its easier to lower rates than to raise them again. They are committing us to the same problems Japan has had the past decade. Better than depression, no doubt, but I do wish they were more up front with the costs of their policies. Treating us like adults is too much to ask?

BTW, I believe you've posted on the importance of proprietor's income in the PCE report before. Any thoughts on that trend?
Nice article!

The more hawkish governors in the Fed seem to keep trying to draw an anti-inflation line-in-the-sand, which then gets washed away by developing events. But I don't think this is a Kabuki dance; I expect to see a few of them openly refuse to sign-on to the Fed's planned reductions.

The rate cut (or cuts) seems to be in the cards, dissent or not, but betcha there's lots of calls in to the ECB to follow us with lower rates, so the dollar doesn't get crushed.
Next post, David. I was disappointed in the October numbers. Or as Tanta likes to write, "Stunned but not surprised."
DCRogers, I'm not sure if anyone agreed to take the hawk slip. Not with the rate spread zooming up almost to where it was in the summer. They have more helicopter work to do.

See the next post.
2% eh? Jeez, where'd that number come from?
"You are the Inflation Hawk for this month". That guv gets to put on the Red and Yellow cape with the mask of the falcon and soar around speaking engagements announcing the Fed's inalterable determination to quash inflation forever, or at least for our time. But other guvs draw the slips that say "Money dropping helicopters standing by", and thus are assigned to don the pilot's goggles and carry a big bag with a dollar sign on it over their backs, while making kindly appearances at banquets like some Wall Street version of St. Nick.

You made my night with that one, MOM. I hope it gets repeated around the net.

Have a good weekend,
Don't laugh at me, man. I'm suffering here.

What I did is theorize that the Bank of MOM had been formed as a joint venture ala MLEC and presented with a group of WaMu loans, Countrywide teasers, and IndyMac Alt-As type loans. I pulled some actual stats for these types of loans from the FWPs, etc. Once the inevitable heart palpitations and dizziness had passed, I tried to figure out what I needed to do to make them stop costing me money. Eventually warming to my task, I wrote off about 15% as pure spec loans.

The problem is that prepayment rates have collapsed, and appear likely to remain in the pits, unless Bank of CF is willing to step in. So the low teaser rates really don't provide the income needed for servicing debt and any sort of minimal return on the capital. A huge number of these are underwater. You can only keep borrowers paying on these debts if the monthly payments remain not too far above rents. Ouch.

The only way Bank of MoM could remain afloat was ruthless foreclosures which generated a flow of money at least. About 6 months out, the Bank of Mom decided to produce more cash flow by financing her REO and rolling them over to Fannie Mae. At about 65% it doesn't look too bad, and it generates some halfway decent fees at least. But Bank of Mom at two years appeared weak and anemic, because her HELOCs and home equities are toxic beyond belief. They are more than 50% unsecured.

The biggest problem was generating enough cash flow to do the required servicing. Bank of MoM could not afford to wholesale modify, because of the high junk rate. If Bank of MoM did that, Bank of MoM just ended up magnifying her losses about a year down the road and collapsing into bankruptcy.

I think IndyMac is in real trouble because they held those loans they intended to sell and now they really don't have the staff they need to service them, nor do they have the cash flow they need to staff up to service them.

All of this assumed extreme Fed kindness, infusions of capital from FHLB, and a blithe willingness of the Fed to accept about anything at the discount window.

The Bank of MoM is now for sale at an extremely reasonable price - say, a jet ride to a country with no extradition treaty. Any takers?

My servicing costs ended up being quite staggering.
Not laughing at all. Just find it odd, how year after year, a number will pop into my head and at some point an expert will find a way to tie it out thru an economic process. Guess it's Rainman meets Wall Street. Now it makes sense when my wife tells me I keep repeating "I'm an excellent driver" in my sleep.
The Bank of MoM really needs a prime rate closer to 1% than 2%. That's how bad it is.

There's a two-sided relationship in the Dunning Effect that many miss. While it's true that the most incompetent at any task vastly overrate their ability, the most competent at any task underrate their ability.
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