by Doug Noland
February 16, 2007
SourceThe profit motive is fundamental to Capitalism. Not well understood, vulnerability to Credit-induced profit distortions is a Capitalist system’s Achilles heel. To be sure, profits malformations develop with differing severities throughout the Economic Sphere. Yet, within the Financial Sphere, grossly inflated financial profits over the life of the Credit Cycle evolve to the point of commanding the real economy and imperiling systemic stability.
More specifically, major Credit booms are dictated by unyielding financial sector expansion, inflated profits, and resulting outsized power and influence. The longer they are accommodated the more entrenched they become. Coupling the impacts of surging financial earnings and pervasive asset inflation, Credit booms generate a “profits” bonanza for those fortunate enough to be employed in key industries – and certainly provide a windfall for the owners, operators, financiers, and brokers of inflating assets. The interplay between Financial Sphere profits and asset inflation creates an increasingly powerful impetus for problematic resource misallocation and economic maladjustment.
Subprime lending is today a microcosm of our financial and economic systems’ vulnerability. Over the prolonged life of this boom, the subprime industry has expanded spectacularly, motivated by easy and seemingly unending profits. And, surely, few industries offer the capacity to grow earnings rapidly as lending to risky Credits during a boom. The industry was instrumental in financing a historic homebuilding Bubble, in the process playing a meaningful role in the ongoing economic expansion. Subprime industry insiders have made fortunes, as have Wall Street investment bankers (and shareholders!). And endless high-yielding mortgages have been a godsend to the collateralized debt markets, the leveraged speculating community, and derivatives markets generally. Today, subprime loan exposures have been disbursed throughout our system’s financial institutions, securitizations, and derivative markets to an extent never before imagined.
It is my view that, at least for the most part, subprime is not a viable business over the entire life of the business cycle. Invariably during the boom – with cheap finance too readily available and a broadening cadre of aggressive lenders, financiers, and speculators actively pursuing their share of ballooning profits – subprime loans will be under-priced and grossly overextended. There will be dire consequences. And the more protracted the boom, the greater will be the systemic impact of the mispricing and overexpansion of subprime finance. Inevitably, there is no escaping the reality that the industry is a Ponzi Finance Unit, acutely dependent upon new liquidity to sustain lending volumes and, hence, asset prices, borrower solvency and loan quality.
Importantly, amidst Credit Euphoria, the overextension of loans will inflate collateral values (home prices) and boost the general economy. With home prices up, unemployment down, and Credit all around, few will be forced into default and foreclosure. Subprime profits will be distorted both by inflated revenue growth (surging loan volumes, gain on sale at inflated prices, and attractive spreads on retained portfolios) and by artificially low Credit losses. The outstanding performance of subprime securitizations and related derivatives will entice only greater speculator interest and sector liquidity overabundance, pushing up the price (down the yield) of risky mortgages. In the real economy, easy finance and housing price inflation spur overbuilding, overspending, and a misallocation of resources.
Subprime lending notoriously understates future Credit costs (overstating current profits/returns), a profits distortion made much more consequential by “gain on sale” accounting, “mark-to-market,” “mark-to-model,” speculator leveraging, and other nuances of contemporary finance. And as long as individual lenders and the industry overall each year expand the scope of lending, rising revenues (from new loans) can remain somewhat ahead of mounting Credit losses (from old loans). But the longer this inflationary process is allowed to proceed the greater will be the unavoidable (Ponzi) bust. Actually, it is my view that with our entire Credit system now operating as a Ponzi Finance Unit, the “prime” mortgage market functions with similar dynamics as those noted above for subprime.
We are in the midst of a unique Credit cycle. The ability for originators to sell loans and immediately book profits; for investment bankers to buy, securitize and immediately book profits; and for leveraged speculators to acquire various securitizations and other derivatives and book easy profits from various spreads and “mark-to-model” - have all made this Credit boom unlike any other. In particular, the ability to securitize loans in the highly liquid ABS/MBS marketplace, as well as insure/speculate on Credit performance in booming derivatives markets, has – or perhaps in the case of subprime, had - radically altered the capacity to prolong the Credit cycle.
Today, Subprime mortgage originator profits are collapsing – lending volumes are sinking; “gain on sale” is reversing to loss; Credit losses (especially from returned “early defaults”) are surging; and the liquidity necessary to operate is disappearing overnight. This has initiated the ugly downside of operating as a Ponzi Finance Unit. The issue of early payment defaults – where investment bankers/securitization pool operators return problem mortgages in droves back to the originator – is rapidly bankrupting this thinly-capitalized industry. And the more acute the risk of insolvency, the greater the incentive for investment banks to rush to dump problem loans while the originator still retains some liquidity (think “bank run”). Wednesday, California originator ResMae filed for bankruptcy after Merrill Lynch sought to return $520 million “worth” of mortgages.
This has enormous ramifications for the industry. Subprime Credit conditions are in the process of tightening – how tight only time will tell. Subprime borrowers this year facing payment resets will confront a changed industry. Those with second mortgages or hoping to add a home equity loan will face much tighter lending standards. Desperate borrowers stretched the truth in 2006 to get new mortgages approved. Such tactics won’t be so easy in 2007. The weakest originators are disappearing and those left will, at the end of the day, be much more prudent and disciplined. Scores of borrowers will be left in the lurch.
But like everything else associated with this most extraordinary Credit Cycle, the analysis is infinitely more complex than what meets the eye. We are undoubtedly in the midst of a major liquidity event for the subprime originators. Additionally, the riskiest CDO and securitization tranches (and related derivatives) will suffer heavy losses. This is a decisive Credit event for the subprime industry, likely marking a major reduction in new subprime loans and escalating Credit losses. Thus far, however, there is little indication that the (paramount) market for “prime” mortgages is being impacted much at all. And when it comes to the subject of overall system liquidity, the current level of tumult could prove less than significant.
In a different – or perhaps typical - environment, recent subprime developments would prompt a nervous reaction from the markets. But today we operate in a most extraordinary backdrop of rampant global liquidity excess, evidenced by ongoing international booms in M&A, securities markets, real estate, energy, and most asset markets. Clearly, a strong inflationary bias permeates Credit systems around the globe. Here at home, continued strong growth in (non-subprime) real estate lending combines with robust corporate and government Credit growth to ensure - for now - continued sufficient non-financial debt growth. More ambiguous but equally important, indications point to continued robust expansion in securities finance, at this stage of the Credit Cycle a liquidity-creating behemoth.
Global interest-rates declined markedly this week. Hawkish comments from chairman Bernanke in the face of subprime tumult would have been troubling. Instead, markets were reassured that the Fed is not poised to commence rate increases (and add to mortgage woes) anytime soon. And with mortgage Credit issues certain to worsen over the coming months, the bond market is again keen to relax and gird for the next loosening cycle. Markets have no doubt how the Bernanke Fed will respond to mortgage problems that risk heightened systemic stress, and this confidence certainly underpins leveraged speculation. The sound of collapsing mortgage companies is music to the ears of the more ambitious.
For now, it would appear the overall Financial Sphere profit motive is little diminished by subprime woes. There is a pocket of fear, yet the vast financial world is still largely dictated by greed. Importantly, however, faltering profits in subprime will entail a change in the flow of speculative finance – at least at the margin, a potentially disruptive development for related securitizations and derivatives. How the unfolding subprime debacle influences (exacerbates or weakens) the flow of finance to “prime” mortgage and corporates is decidedly up in the air, especially if this week’s bond market rally presses on.
But another swath of the now enormous leveraged speculating community is in the process of being clipped, leaving the leveraged players at least somewhat more vulnerable. And perhaps even the Wall Street firms will decide to ratchet risk exposures down a tad at the margin. It is worth noting that the yen rallied abruptly this week, placing yen “carry trade” bets on somewhat less sure footing. The dollar index closed down almost 1% for the week, slipping again below 84. Sure, the bulls can celebrate the ongoing global equities market melt-up. This, however, doesn’t alter the troubling reality that Monetary Disorder is in Full Swing. We should expect global markets to be unsettled and worthy of careful analysis. Subprime may not be a factor precipitating meaningful liquidity destruction, but it could nonetheless play a role in further destabilizing a highly unstable financial system.