FYI | Mar 19 2007
By Greg Peel
“For years overseas investors have been buyers of American corporate debt, mortgage-backed securities and agency bonds at record pace, helping cover the US current-account deficit – the broadest measure of international transactions.
But the rapid unraveling of the US sub-prime mortgage industry, which is stirring new concerns about the already weak housing market, could change all of that.”
So wrote Reuters’ Jennifer Alban last week, as fears were growing that sub-prime mortgage defaults in the US were the beginning of a potentially significant bubble collapse, the implications of which would resonate through global financial markets. Alban noted that US banks doubled the amount of collateralised debt obligations (such as packaged and securitised mortgages) in the past two years to US$2.6 trillion. Foreigners have been big buyers of these instruments in the global chase for yield.
Thus the implication is that the panic over sub-prime might escalate into a more general shift out of debt securities, which is bad news for the US markets. On a more macro level, defaults and subsequently tightened mortgage guidelines could also lead to a turn down in US consumer spending.
US consumer spending is not only the powerhouse of the US economy, it is the powerhouse of the global economy. While Asia saves and Europe remains frugal, Americans (and Australians) have been spending with their ears pinned back. Hence the massive current account deficit. If Americans stop spending, the world could be rapidly plunged into recession.
The sub-prime mortgage market is estimated to comprise about 25% of total US mortgages outstanding, according to UBS. It has been the fastest growing area of lending, accounting for some 35% of new mortgages in the past 12 months.
(The level in Australia is much smaller. The equivalent of sub-prime is what we know as lo-doc and no-doc loans – loans made to those with poor credit ratings or little security).
It is no surprise that sub-prime mortgages should become a victim of the US housing slump. Such loans are made to low-income Americans and carry higher risk of delinquency or default. The sub-prime delinquency rate rose to 15.25% in the fourth quarter of 2006. By contrast, the “prime” mortgage delinquency rate was a mere 2.57%.
The problem with defaults is that it aggravates an already weak housing weak through foreclosure sales. Defaulters will cease to be spenders. Tighter mortgage availability will flow through to less spending. General mortgage fear will put a curb on spending.
The reality is however, as noted by UBS, that while sub-prime mortgages may represent 25% of mortgages outstanding, the average sub-prime mortgage holder is in the bottom 10% income group. The top 40% income group attributes to about 50% of the spending. And higher income earners are a world away from sub-prime woes.
Real person income growth in the US is still relatively healthy. Jobs are plentiful, nominal wages are rising, and inflation appears to be under control. What is disappointing is that the US housing market appeared to be bottoming, but the sub-prime scare will likely see it remain weak for more time to come.
Goldman Sachs strategists note that the spill-over has led down the Goldman Sachs Housing basket (financial and building stocks) by 8% since February. However, they also note there has been little if any sign that equity markets are expecting any flow-through to the consumer sector. That growth basket has rallied since the beginning of the year, and is currently trapped in a range. Says Goldman’s:
“For now, the internals of the market suggest sub-prime issues are a focused risk event and not a broader macroeconomic one.”
In terms of a greater global macroeconomic influence, UBS suggests activity outside the US is mostly encouraging. Europe (and particularly Germany – still the world’s third biggest economy) appears to be gaining economic momentum, with investment spending and consumption shifting to domestic demand. The domestic picture also appears brighter in Japan (number two). Activity remains brisk in China (number four). The point is that as the rest of the world comes to rely less on Americans to buy their products, they are less susceptible to a slowing US economy.
UBS suggests the US economy is unlikely to slide into recession. It is, however, likely to be weaker at 2% GDP growth compared to levels of 3.7% over the last three years.
Thus while UBS accepts fears that the sub-prime problem could turn into a wider “credit crunch”, and that stranger things have happened in the past, the strategists suggest:
“The probability of a credit or liquidity crunch remains remote, in our view, given the overall healthy fundamentals in the US and global economies. As such, we’re ‘sticking to our guns’ that the recent market sell-off presents more opportunity (to look for value) than risk. We therefore retain our global overweight recommendations to equities and real estate and our underweight recommendations to global government and corporate bonds.”
And Goldman Sachs JB Were strategists have concluded:
“Our instincts here are that there is a good possibility of economic pressure – transmitting to the consumer and the wider economy – echoing the Goldman Sachs economics view, with widespread financial crisis a much less likely outcome.”
Danske Bank analysts agree that while the sub-prime mortgage situation is serious, and it could be an early warning sign of more widespread trouble in the credit market, “we expect the problems to be contained within the sub-prime sector”.
“As a whole”, says Danske, “we expect no large ramifications on the macro economy from the sub-prime crisis.”
One might call that the bullish view. And for every bullish view there must also be a bearish one. It is no surprise that the most alarming comes from the mouth of Morgan Stanley chief economist and celebrated uber-bear Stephen Roach.
“From bubble to bubble – it’s a painfully familiar saga. First equities, now housing. First denial, then grudging acceptance. It’s the pattern and its repetitive character that is so striking. For the second time in seven years, asset-dependent America has gone to excess. And once again, twin bubbles in a particular asset class and the real economy are in the process of bursting – most likely with greater-than-expected consequences for the US economy, a US-centric global economy, and world financial markets.”
The equity bubble to which Roach refers is the dotcom bubble of 2000. When dotcom companies were leading the US stock market to new highs, based on hype alone and not by earnings, equity market analysts were not concerned. The excesses were concentrated in about 350 companies that together represented only about 6% of the total capitalisation of the US equity market. Were this bubble to burst then the ramifications for the overall market would not be significant.
Sound familiar?
When the bubble burst the US equity markets proceeded to lose 49% of their value over an 18 month period, and the US slipped into mild recession, pulling the rest of the world down with it.
Roach notes a similar lack of concern given the small size of the sub-prime mortgage market, and suggests “as was the case seven years ago, I suspect that a powerful dynamic has now been set in motion by a small mispriced portion of a major asset class that will have surprisingly broad macro consequences for the US economy as a whole”.
In short, Roach is undeterred by notions that US consumer spending is not being affected. He believes that domestic demand has outstripped the underlying support of income generation. In the absence of rapid asset appreciation (such as housing values) there is a resultant overhang, and that needs to be “marked to market”. “The spillover is a principal characteristic of the post-bubble shakeout”.
The US economy has already slowed to 2% GDP growth from 3.7%. Consumer spending on the other hand has only slowed from 3.7% to 3.2%. What is wrong with this picture? Any sudden pullback in consumer spending could be the straw that breaks the camel’s back, says Roach.
And Roach believes the case for a consumer spillover is “compelling”. Real private compensation, he notes, remains US$400 billion below the trajectory of the typical business cycle expansion. At the same time, debt and debt service obligations have surged to all-time highs while the income-based savings rate has dipped into negative territory for the first time since the 1930s. The difference has been provided by home-owners extracting equity from rising residential property values. As the housing bubble has burst, that consumer prop has now been kicked away.
Roach blames Greenspan (former Fed chairman). The role of the central bank, says Roach, is to “take the punchbowl away just when the party is getting good”. But in 2000 Greenspan encouraged dotcom speculation by suggesting the surging Nasdaq represented a once-in-a-lifetime paradigm shift, just before the market peaked.
In 2004 Greenspan urged home-owners to switch from fixed to floating rate mortgages, and in 2005 he extolled the virtues of sub-prime lending.
Roach suggests the US “got into this mess” when it responded to the dotcom bubble burst by rapidly easing monetary policy. This set the market up for another series of bubbles – residential property, emerging markets, high-yield corporate debt, and mortgages. The yen carry trade added “high-octane fuel” and saving shortfall resulted in “the mother of all current account deficits”. The “new-paradigmers” weren’t concerned, just like they aren’t at the peak of every bubble.
It is hard to tell when the “great unravelling” might occur, says roach. As bubbles beget bubbles the ultimate demise may still be some way away. But then either the Big Bubble bursts or we get the inflation of another bubble simply to buy more time. Unless (present Fed chairman) Bernanke can break the “daisy-chain” of Greenspan’s legacy, says Roach:
“I am convinced that this liquidity-driven era of excesses and imbalances will ultimately go down in history as the outgrowth of a huge failure for modern-day central banking. In the meantime, prepare for the downside – spillover risks are bound to intensify as yet another post-bubble shakeout unfolds.”
For what it’s worth, Stephen Roach has been bearish for many years.