The Fed's desperation: Trying to Prop up Housing Again
What do you call it when assets double in a few short years? Most folks call it hyperinflation. That's what happened with housing. As the mess unwinds, a few folks are caught out: new homebuyers, construction companies and lenders. Other folks, like the overwhelming majority of Americans, would actually benefit from home price deflation.
To begin with, raw materials would get cheaper. More importantly, folks who really can afford housing would be able to buy in. Lets face it, the economy benefits when the stakeholders are stable.
But, alas, the Fed just can't keep their hands off. First, they reduced the cost of borrowing by 1%. Citigroup and other lenders now have lower costs to service the loans that they took out to cover their positions. That helps cash flow dramatically. But the underlying problem remains: what do you do with $1T of debt that won't get paid back anytime soon?
The Japanese faced the same dilemna in 1990 when their housing market bubble burst. EXACTLY. THE. SAME. Lenders had tons of non-performing loans on their books. So the Central bank of Japan created a fund and bought these underperforming loans. The idea was that banks - no longer weighed down by bad debt - would start lending again. Instead, Japan fell into a ~15 year economic malaise. This was primarily due to folks living under the massive debt.
Interestingly enough, because of the safety net, Japanese banks continued to make loans that had weak chances of being repaid.
At the end, Japanese homes were worth 1/10 of their value at the height of the boom.
The Japanese consumer reduced spending and Japan entered a deflationary spiral.
I was there throughout the late 80s and into the 90s. I saw the excess first hand. I was a Research Fellow at the Kyoto University Institute of Economic Research from 1989-1990. My area of study was Japanese consumer spending trends. I studied the conspicuous spending habits and I was able to speak with Industry leaders, all of whom felt the Japanese consumer would never be price sensitive. Ooops.
It is from this experience that I am able to look at the US market. The US economy is a lot different from Japan's. Our economic system is a lot more stable. But we are also a lot more dependent on debt and on services, whereas the Japanese had lots of cash and actually made things.
The point I am making: a severe reduction of wealth coupled with massive debt will occur and will affect a great many consumers and thereby push down the US economy. That is a fact. The other side is that anyone with cash and patience will find themselves much wealthier.
The cornerstone is individual debt. Nothing the Fed or the White House is doing will in any way change that debt load. The only thing that will help out the homeowner is for prices to increase 20%+ and that isn't going to happen. And folks who think that they are rolling in the paper profits because they bought back in 2001 - you better think again. We are heading for 1999 prices in nominal terms. You will be underwater as well.
The problem for the individual debtholder is different from the lender debt holders. An individual homeowner has debt and a house. They can liquidate the house and use the proceeds to pay off all or most of the debt. Lenders face the liquidity problem. They have debt and then they these pieces of paper that are backed by housing property. Those are often called CDOs.
The problem is that there is no market for CDOs. Nobody is buying, so they have no value.
http://www.bloomberg.com/apps/news?pid=20601087&sid=ameYYjeqjIDA&refer=home
All CDO sales are down by over half and Subprime CDOs don't exist.
And now lenders face a fire sale. First, they have to increase capital in reserve because - by law - they must maintain a ratio of capital to loans. With the CDO value down, their capital position is down. It's now a downward spiral: the more they declare the CDOs are reduced in value, the more cash they need. And the more urgently they need to sell the CDOs.
The second cause of the fire sale is the tax year is over in a few weeks. They have to clear the books up. Now. Not in a year. And nobody will buy these CDOs, so they are worth $0.
Imagine the pandemonium if Citigroup had to declare $49B of CDOs were worthless. Assuming that the $49B in CDOs was used for lending, pandemonium will occur. Citi needs to find $49B to back up their loan positions. That means massive selling of assets, and no lending. For world markets, that means a great day - companies will get assets on the cheap. Other lenders can step in where Citi vacates. But Citi gets hurt. Boo hoo.
I am not exaggerating, by the way. Citigroup has $49B in subprime CDOs. Citi hasd to put a value on them or face the consequences I describe. It really is that bad. Major lenders will be goin gunder and absorbed. The markets will be roiled.
To try and soften the blow, the Fed is now going to buy Citi's assets. Just like Japan did in the 1990s.
http://news.bbc.co.uk/1/hi/business/7143823.stm
The Fed is going to loan Citi money and allow the CDOs to be used as collateral. They are pricing the CDOs at 85% face value. Now, this is obviously chicanery at its finest - the market value for the CDOs is 30% of face value for subprime (I know, I said the CDOs were worth $0, but I was exaggerating a bit).
In being generous, the Fed accomplishes a few things.
1. Citi gets maximum cash - they really need cash and they wil lget what they need
2. A value is placed on the CDO. Suddenly, there is a market for the debt and an artificial floor is created
3. The worthless asset is moved (temporarily) off the books
Technically, the isn't buying the debt. But they have created a value for it.
The government has to avoid the stigma of bailing out the lenders from their own self inflicted stupidity. Whether or not it is a good thing, folks do not want the taxpayer to foot a $1T bill for banks. And the US budget can't afford it.
So the Fed is only making a loan and at some point Citi will repay it. Maybe like Chrysler did. But this is really accounting chicanery. The entire premise is built on the faulty concept that housing prices will stabilize. They won't. So the CDOs will fall in value.
I doubt that Citibank will default. But a few years down the road, maybe the $49B loan is re-negotiated to $10B.
I won't say if this is good or bad. It does prevent a very painful scenario. I do think it postpones the day of reckoning, and that we will see economic malaise.
Most folks are starting to get the message. They shouldn't buy houses that are 10x their salaries. To remind them of this concept, lenders are back to setting stricter terms. I don't think we'll see very many $40K salaried secretaries buying $1M homes because they will need a $200K downpayment.
The only guarantee is this: come next year, bankers will be back to giving themselves huge bonuses.
To begin with, raw materials would get cheaper. More importantly, folks who really can afford housing would be able to buy in. Lets face it, the economy benefits when the stakeholders are stable.
But, alas, the Fed just can't keep their hands off. First, they reduced the cost of borrowing by 1%. Citigroup and other lenders now have lower costs to service the loans that they took out to cover their positions. That helps cash flow dramatically. But the underlying problem remains: what do you do with $1T of debt that won't get paid back anytime soon?
The Japanese faced the same dilemna in 1990 when their housing market bubble burst. EXACTLY. THE. SAME. Lenders had tons of non-performing loans on their books. So the Central bank of Japan created a fund and bought these underperforming loans. The idea was that banks - no longer weighed down by bad debt - would start lending again. Instead, Japan fell into a ~15 year economic malaise. This was primarily due to folks living under the massive debt.
Interestingly enough, because of the safety net, Japanese banks continued to make loans that had weak chances of being repaid.
At the end, Japanese homes were worth 1/10 of their value at the height of the boom.
The Japanese consumer reduced spending and Japan entered a deflationary spiral.
I was there throughout the late 80s and into the 90s. I saw the excess first hand. I was a Research Fellow at the Kyoto University Institute of Economic Research from 1989-1990. My area of study was Japanese consumer spending trends. I studied the conspicuous spending habits and I was able to speak with Industry leaders, all of whom felt the Japanese consumer would never be price sensitive. Ooops.
It is from this experience that I am able to look at the US market. The US economy is a lot different from Japan's. Our economic system is a lot more stable. But we are also a lot more dependent on debt and on services, whereas the Japanese had lots of cash and actually made things.
The point I am making: a severe reduction of wealth coupled with massive debt will occur and will affect a great many consumers and thereby push down the US economy. That is a fact. The other side is that anyone with cash and patience will find themselves much wealthier.
The cornerstone is individual debt. Nothing the Fed or the White House is doing will in any way change that debt load. The only thing that will help out the homeowner is for prices to increase 20%+ and that isn't going to happen. And folks who think that they are rolling in the paper profits because they bought back in 2001 - you better think again. We are heading for 1999 prices in nominal terms. You will be underwater as well.
The problem for the individual debtholder is different from the lender debt holders. An individual homeowner has debt and a house. They can liquidate the house and use the proceeds to pay off all or most of the debt. Lenders face the liquidity problem. They have debt and then they these pieces of paper that are backed by housing property. Those are often called CDOs.
The problem is that there is no market for CDOs. Nobody is buying, so they have no value.
http://www.bloomberg.com/apps/news?pid=20601087&sid=ameYYjeqjIDA&refer=home
All CDO sales are down by over half and Subprime CDOs don't exist.
And now lenders face a fire sale. First, they have to increase capital in reserve because - by law - they must maintain a ratio of capital to loans. With the CDO value down, their capital position is down. It's now a downward spiral: the more they declare the CDOs are reduced in value, the more cash they need. And the more urgently they need to sell the CDOs.
The second cause of the fire sale is the tax year is over in a few weeks. They have to clear the books up. Now. Not in a year. And nobody will buy these CDOs, so they are worth $0.
Imagine the pandemonium if Citigroup had to declare $49B of CDOs were worthless. Assuming that the $49B in CDOs was used for lending, pandemonium will occur. Citi needs to find $49B to back up their loan positions. That means massive selling of assets, and no lending. For world markets, that means a great day - companies will get assets on the cheap. Other lenders can step in where Citi vacates. But Citi gets hurt. Boo hoo.
I am not exaggerating, by the way. Citigroup has $49B in subprime CDOs. Citi hasd to put a value on them or face the consequences I describe. It really is that bad. Major lenders will be goin gunder and absorbed. The markets will be roiled.
To try and soften the blow, the Fed is now going to buy Citi's assets. Just like Japan did in the 1990s.
http://news.bbc.co.uk/1/hi/business/7143823.stm
The Fed is going to loan Citi money and allow the CDOs to be used as collateral. They are pricing the CDOs at 85% face value. Now, this is obviously chicanery at its finest - the market value for the CDOs is 30% of face value for subprime (I know, I said the CDOs were worth $0, but I was exaggerating a bit).
In being generous, the Fed accomplishes a few things.
1. Citi gets maximum cash - they really need cash and they wil lget what they need
2. A value is placed on the CDO. Suddenly, there is a market for the debt and an artificial floor is created
3. The worthless asset is moved (temporarily) off the books
Technically, the isn't buying the debt. But they have created a value for it.
The government has to avoid the stigma of bailing out the lenders from their own self inflicted stupidity. Whether or not it is a good thing, folks do not want the taxpayer to foot a $1T bill for banks. And the US budget can't afford it.
So the Fed is only making a loan and at some point Citi will repay it. Maybe like Chrysler did. But this is really accounting chicanery. The entire premise is built on the faulty concept that housing prices will stabilize. They won't. So the CDOs will fall in value.
I doubt that Citibank will default. But a few years down the road, maybe the $49B loan is re-negotiated to $10B.
I won't say if this is good or bad. It does prevent a very painful scenario. I do think it postpones the day of reckoning, and that we will see economic malaise.
Most folks are starting to get the message. They shouldn't buy houses that are 10x their salaries. To remind them of this concept, lenders are back to setting stricter terms. I don't think we'll see very many $40K salaried secretaries buying $1M homes because they will need a $200K downpayment.
The only guarantee is this: come next year, bankers will be back to giving themselves huge bonuses.
posted by Andrew at
7:24 AM
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