How Sudden Was The Debt?

The title of this blog is obviously a play in words, but it also points out a very troubling fact: people got into a lot of debt, very fast. How fast?

Here is a chart that shows exactly that (click to enlarge). It plots the annual rates of growth in household debt and personal income. They both grew at the same rate, more or less, until 2000 and then diverged very sharply, with debt rising in double digit rates and incomes trailing badly. This debt - income "gap" has persisted for a long six years and finally seems to be abating in 2007 (based on 6 month data projections).

Data:FRB

No mystery about what happened: homes used as piggy banks and the asset economy - instead of higher incomes generated through an expanding production base. The negative effects of this 2001-2006 gap are going to be with us for a long time, pressuring consumption and investment. The gap will also produce rising and persistent debt defaults, since the debt/income imbalance was so large and so long-lasting.

There is also no mystery about how this dangerous situation can be overcome; blue line significantly over the red line, for many years: i.e. personal income must rise much faster than debt, so that borrowers can comfortably service and gradually reduce their overextended debt load.

How can this be accomplished? Certainly NOT by creating another debt-induced asset bubble (stocks, commodities, whatever...). This will only make the two lines diverge again and the subsequent correction will be that much more painful, because -in the end - all debt must be serviced through earned income. Otherwise it all simply turns into a Ponzi scheme.

Housing Takes It On The Chin - Again

Existing home sales in September dropped to the lowest level since the NAR started keeping records in 1999. Not exactly a surprise.. But that number does not tell the whole story. What matters most to the economy is not so much the number of homes sold, but their dollar value. So I produced a couple of charts for existing and new home sales tracking gross dollars instead of units.

First, the new home data (click on the chart below to enlarge).

Building new homes has gone from being a $400 billion/year business, to one doing around $225 billion/yr and dropping fast (red line). More worrying still is that builders can't get rid of inventory yet, which is stuck at around $150 billion (at average prices). The result is that the Inventory-to-Sales ratio (blue line) has rocketed from 0.35 to 0.65. I don't know of many, if any, businesses that can long withstand a doubling in their inventory/sales ratio. There is more trouble ahead for the home-builder sector.

Next, the data on existing home sales.

The NAR provides free data that go back 12 months - historic data are "available for purchase" (mind, I'm not complaining; everyone's entitled to a living - including brokers). But even so, they tell the story.

Here, we are dealing in the $$ trillions. In just 12 months existing home transactions have shed $400 billion in annual turnover (red line); that has to hurt mightily everyone involved. This translates to lower commissions, closing costs, loan points, purchases of new appliances and furniture, moving fees, etc. Data: NAR

The inventory of existing homes for sale is currently valued at $1.1 trillion (average prices, green line) and the Inventory-to-Sales ratio has jumped from 0.55 to 0.88 in just 9 months (blue line). While the higher inventory is not exerting the same kind of pressure as unsold new homes put to builders, it is still a significant drag on economic activity. People who can't sell their homes as fast and/or for as much as they originally calculated, are not likely to go out spending freely - the "wealth effect" turns around 180 degrees, particularly if their homes were used as HELOC piggy banks.

____________________________________________

"New Home Sales Unexpectedly Rise" (!!!!!)

This is one of the most shamefully spun headlines I have ever seen in financial reporting. They must think we are beyond stupid and well into moron territory.

The facts: Sales for September came in at 770.000 units, exactly as expected. August was originally reported at 795.000, but with today's report they were revised down significantly to 765.000. So this loss of 30.000 units was reported as a... rise!

Tell you what: let's permanently cut the reporter's salary by $35.000 in October, but then give him a $5.000 "raise" in November. How happy is he going to be about this "unexpected rise"?

This is getting Orwellian.

Quant Quandary

Hedge funds pulled in $45 billion in new money during the third quarter of 2007, bringing the nine month total to $164 billion vs. $126 billion for the whole of 2006. That's impressive and goes a long way in explaining why markets - particularly emerging markets - are performing the way they are. People are still throwing tons of high-powered money at them. I say "high-powered" because hedge funds can and do leverage, sometimes as much as 50-to-1, depending on their strategy. So one dollar raised may end up as twenty dollars in Brazilian shares. Furthermore, we now have funds of hedge funds becoming very popular, further hiking total leverage (ding, ding, ding - does anyone hear the alarm bell ringing? Read your financial market history, folks. Hint: trusts of trusts in 1929).

Total assets for hedge funds reached $1.81 trillion. And therein lurks a serious quandary for quant hedge funds, who depend on being nimble and highly specialized. For example, if a manager identifies a discrepancy or mis-pricing in a market he may put on a spread trade to capture the difference with seemingly little risk. However, as more and more managers identify such opportunities the pickings become slimmer - the law of lower marginal returns sets in. Typically a manager then has two choices: find another opportunity, or hike leverage on his existing trade to make up for the smaller profit margin.

With so many hedge funds now scrutinizing the entire world for relative value trades, new opportunities are not easy to find. So, I bet what is happening is this:

a) Leverage is being increased on existing trade strategies and,
b) Funds are increasingly taking outright positions, i.e. becoming net long or short, exposing themselves to the full force of the market, instead of putting on spread trades.

Why do I say this? Let's see...

• The equity arbi funds that take spread positions based on LBO/takeover transactions can't be doing well. The pipeline has run dry and existing deals are either getting re-priced or cancelled altogether. There are big losses simmering there...
  
• The SIVs and other conduits borrowing short-lending long are dead. All other hedge funds that followed the same strategy are in trouble, too.
• The CDS-equity correlation party is over, too. Broad equity indices are near all-time highs, but corporate CDSs are nowhere near as cheap as before. Risk is now being "re-priced", to say the least.
  
• One of the only games left is one of the oldest: momentum trades. In other words, identify a market(s) that is trending strongly and join the party. And guess what? This is exactly what is happening: you can see it in the way that bullish markets extend and extend, be it Chinese stocks or crude oil.

Bottom line? It seems to me that quants are not being as conservatively "quantish" as before... Loaded with new money to "invest" (as Alan Greenspan famously said about wild-eyed speculation before the dotcom crash, "is that what we call it now?") and fewer arbi/spread opportunities, the money must increasingly be going to outright speculative positions.

Add increased leverage and what we have going on here is bubble pumping in spades.

Oh, and I forgot to mention... Anyone still thinking that hedge funds are the playground of the rich and famous is woefully behind the times. ANYONE can buy into a hedge fund these days - some with as little as $10.000: i.e. 100% retail investor stuff. This occurs through the aforementioned funds of funds and - no surprise - the biggest piece of the $45 billion raised in the 3Q2007 went to...funds of hedge funds. A cool $22.5 billion. Contrast that with the puny $990 MILLION raised by plain old mutual funds during July and August and you have yourself a trend, eh?

Did someone say the retail investor is absent from this bubble? Don't think so....

Still At Work, But Not For Long

One puzzle that even Fed presidents find difficult to solve has to do with construction jobs. Though new housing starts have plunged, so far there have been no massive layoffs in the sector - at least not as measured by the BLS (see chart below).

Employment in residential building construction (seasonally adjusted) Chart: BLS

The two explanations that I hear most often have to do with (a) illegal, undocumented aliens not being counted and (b) switching work to commercial construction. Both are correct to a certain extent, but: (a) I find it hard to imagine that the proportion of jobs held by aliens was very much higher in 2006 than, say, 1988-90 and (b) the BLS does not show a commensurate increase in the number of jobs for the non-residential construction sector - employment there is flat. Plus, the number of jobs in the housing construction sector doubled since the last major housing recession in 1992, in line with housing construction activity (see chart below). So, the puzzle remains...


The answer to the puzzle is much simpler, I believe. Unlike other housing recessions, this time housing starts fell off a cliff from a record high level - everything happened very, very fast. This means that there was still a lot of work to be completed at the time. Now, a builder will not abandon a project in the middle of construction - he has already invested too much money. Knowing that things are turning negative on the demand side, what he will do, instead, is rush every worker available to the sites already in progress, in an effort to complete and sell as many houses as possible, as soon as possible. This is the logical reaction to a dropping market: houses that come late to the market will fetch lower prices. Look at the chart below (click to enlarge): starts have plunged, but units still under construction are high. This can only mean that builders are working hard to finish existing projects already in the pipeline. And that's why construction workers are still at work.


But what the future has in store is another matter altogether. Given the collapse in starts, construction layoffs are going to occur suddenly, too, just as soon as work in progress is finished. And that's when we may see half a million jobs disappear within months.


ADDENDUM: When will the job losses happen?

First a chart - you definitely need to click on it to enlarge and study it. Too many squiggly lines.

The top two lines are starts and completions; they track quite closely, meaning that builders are completing what they started and not really abandoning many projects.

The next two lines present somewhat of a puzzle. The blue line is sales and the pink one units under construction. After tracking for decades, as one would expect, after 1996 sales overtook construction significantly. What happened? It must be that cancellations became a significant factor (figures for sales are reported when contracts are signed and do not adjust for subsequent cancellations).

The green line at the bottom is the most interesting of all: new houses for sale. They are stuck near all time highs, meaning that inventory is a big problem.

OK, let's put it all together, from the jobs viewpoint:

a) New construction activity (starts) is collapsing. Future employment will decline.
b) Sales are approaching the number of units under construction, after being significantly higher. Builders are building fewer buildings, but sales are dropping faster.
c) The result is that inventory is not coming down. Builders will have to do fire sales and cut costs - i.e. cut jobs soon.

When and how much? Given the last three months data on starts, units under construction will probably drop to the 575.000/yr. level by year-end (September was at 675.000). This level is the same as in 1998, when residential construction employment averaged 725.000 jobs (September was at 981.000). So I project a loss of ~ 250.000 construction jobs in the next three months. Furthermore, starts currently are at 1993 levels, when employment was at 580.000 jobs and it seems to me we will drop to that level within another three months, for a total of 400.000 jobs lost in six months.

If starts keep going lower then construction jobs will drop even further.

__________________________________________________________________

With all thy knowledge, get going...

I added a strip of finance/economics book recommendations to the right of the blog. I will update them from time to time.

Remember The Buckets

As the mortgage crisis unfolds, I think it is useful to remember that most mortgage-backed structured finance products use a cascade configuration. Practically, it takes some time until defaults are reflected in the cash flows of the AA and AAA tranches, because the first "hits" are taken against the lower-rated "buckets" and against whatever reserves were maintained as a cushion. From the perspective of the AA-AAA CDO holder, nothing has changed in his cash flow: he/she is still getting paid regularly.

What this means is that, absent a functioning secondary market, holders resort to mark-to-model to price their portfolios; since the cash flows are still unchanged for the AA-AAA tranches, models come up with high valuations. This explains why all concerned (banks, brokers and presumably hedge funds) took such relatively small write-offs on their CDO positions. But it also explains why holders of large positions in supposedly high quality bonds are in such a hurry to form the Super-SIV and get 'em off their balance sheets (but apparently no one else is biting). Because...

The big hits for the AA-AAA buckets are still in the future and they are not going to come from borrowers' missed monthly payments - that's just interest (mostly). As the process moves along from delinquency to default, repossession and eviction, the lower buckets may still be able to absorb some, if not all, of the losses stemming from lower monthly payments. The real crunch will come when REO auctions finally occur and the real estate is sold at prices significantly less than what is owed. That's when large principal losses will be realized, flooding the lower tranches and cascading in waves onto the AA-AAA buckets.

The sad truth is that there are no AA-AAA CDOs, not in the traditional corporate bond sense, anyway. Their structures make them inherently unstable past a critical point, after which their performance becomes non-linear on the downside. The banks know this very well (they engineered them, after all) and that's precisely why they don't want to hold them - it has nothing to do with lack of transparency or liquidity. Such products are large ticking bombs; their manufacturers can calculate with relative accuracy when they will explode, given timely data on delinquencies and defaults. As in any bankruptcy, how much money will be recouped will depend on the prices realized from the auctions, minus costs and fees.

That's why hedging via the ABX indices is becoming rapidly more expensive, even for the AAA tranches, and also why the rating agencies are finally starting to downgrade such issues by the tens of billions.

Chart: Markit

The Debt Pie

Today, being Saturday, one chart: the make-up of the debt of the non-financial sector, i.e. that owed by households, the government and corporations - everyone except banks and other financial institutions. As of the second quarter of 2007, it amounted to nearly $30 trillion or 220% of GDP.

Data: Federal Reserve

What immediately stands out is the size - absolute and relative - of mortgage debt. Ultimately, this is the very reason why the bursting of the real estate bubble is real cause for alarm. A very large percentage (over 50%) of this $13.8 trillion in mortgage debt has been securitized and distributed widely in the US and abroad as mortgage pools, GSE securities, CMOs, CDOs, etc.

Therefore, the mortgage debt crisis is not an isolated risk event. It has the potential to shake the whole asset/credit economy from its very foundation and it will take much more radical solutions than band-aids (eg super-SIVs) to prevent serious consequences. It seems to me that this problem, just like peak oil and climate change, is going to end up being highly political and not merely technical or financial.

Complexity and Non-Linear Consequences

The Tower of Babel. Easter Island. Kurt Godel and Werner Heisenberg. A nuclear reactor. Innovative Finance. Rube Goldberg. Bread crumbs.

If the connections between the above references are not quite clear, allow me to explain.

The tower of Babel is one of mankind's oldest warnings about the destructive forces unleashed when complexity takes over. Interestingly, complexity was God's punishment. Think about that for a second: complexity as punishment! There is a lot of wisdom in The Bible.

Easter Islanders built a highly complex societal system for the purpose of constructing, transporting and erecting the famous moai statues dotting the shores of their island. They became so absorbed in this activity, that they eventually stripped the land of all resources and imploded.

Kurt Godel was the mathematical genius who proved that there are theories that can never be proven. Heisenberg took that idea one step further into the physical world with his Uncertainty Principle. In other words, there are things we do not know and which we will never know.

Pause: complexity is a necessary element in any social system. The question is, how much complexity is beneficial? How far do we go without eventually producing a tower of Babel? If we go too far in creating complex systems we reach a point where minute variations quickly result in disproportionate effects, like the butterfly in China creating a storm. Enter Godel and Heisenberg: we know that we will have unexpected variations, because we cannot know and control everything a priori.

Furthermore, the results may be catastrophically non-linear. The nuclear reactor is a perfect example: a small increase in the number of neutrons leads to an uncontrolled chain reaction. Another example is a chemical reaction that proceeds very slowly on its own until we introduce a catalyst, at which point it will run away and cause an explosion. Highly complex systems are prone to non-linear behavior; and the more complex they become, the higher the probability of critical, non-linear events.

Second pause: with "innovative" finance we have constructed the equivalent of a series of global financial nuclear bombs. We have sliced and diced every conceivable stream of income and variation from "norm" and re-packaged them into new "products". In previous posts I showed how a simple mortgage spawns third and fourth derivative products like CMOs, CDOs, CDSs, hubrid CDSs and CPDOs, each of them a step up in complexity and price volatility from the one before, all linked together in a tight relationship. The same has happened with equities, insurance receivables, energy, shipping... you name it, our financial engineers have taken it apart and put it back together like so many Lego blocks.

It looks to me that, after a point, all we have accomplished with "innovative" finance is the construction of a number of Rube Goldberg contraptions that end up doing very simple tasks through a series of inter-connected complicated and convoluted steps, each prone to its own risk of failure. Each individual risk may be small, but added together they can propagate toward total collapse. The risk is now in the system itself, not in the exogenous events.

Why have we done this? Because at each step there is "friction", aka fees and commissions. Crumbs, as Sherman McCoy from Bonfire of The Vanities would put it. But Tom Wolfe wrote his epic at a more innocent time, even though it was only 20 years ago. Today we are no longer content with the few crumbs that remain on the table. Instead, we as investment bankers, traders and speculators, grate entire loaves into bread crumbs, take out as many as we possibly can for ourselves and then put them back together for sale as bread sticks.

Credit Risk Rising Again

Credit risk is being marked up once again.

The most pressure is building in mortgages. The ABX (residential) and CMBX (commercial) indexes are declining fast, many of them making new all time lows - including the highly rated tranches. There is obviously an increased push to hedge CDO inventory sitting in dealers' hands and various portfolios, SIVs included. Fresh downgrades from S&P and losses at mono-line insurers are also a significant factor, as is Cheyne's latest announcement about its SIV.

Some charts from Markit:

ABX: AA tranche for the latest 2007 vintage

ABX: BBB- tranche for the latest 2007 vintage

The CMBX charts, tracking commercial real estate loans, are inverted, i.e. they show yield spreads.

CMBX: A tranche

CMBX: BBB tranche

Repeat of August? Who knows, but just like then CDX spreads are slowly rising once more (corporate bond risk) and so are LCDX spreads (LBO loan risk). You can follow those on Markit's site, too. Doesn't look good.

Fishy Pols

Have you noticed how even Presidential races have now been reduced to dollar figures? I don't mean the effect that money has on shaping political agendas and voter perceptions - this has been going on since at least the time of Pericles. I am referring instead to the assessment of candidates' appeal to voters based on how much money they have raised in their election "war chests". Hillary is deemed to be the frontrunner because she has raised X million dollars more than Barack, who is ahead of John Edwards and so on and so forth. This is so much like the order book of an IPO (initial public offering), for chrissakes. The more orders that flow in during the book-building period the better the chances that the issue will be "hot" and open for trading at an immediate premium. Hillarydotcom and Barrackdotcom.

We have financialized everything, so I should not be surprised. But I still think it is troubling and, ultimately, very dangerous for the quality of our democratic process. Money cannot measure the quantity and certainly not the quality of political ideas and principles. Judging politicians by their fund-raising prowess is akin to judging fish by their price at the fishmonger's stand, instead of by how they smell. Spoiled tuna will send you to the hospital no matter what the price.

Super SIV? No: PBoC Policy

No. This post is not going to be about the Super-Sieve, the structure that will act as sinful banks' SIV Purgatory. Intelligent people with a modicum of market knowledge and experience can come to their own conclusions, always depending on their individual perspectives. All I can do is refer history buffs to the Borgia Pope.

On to other, more important news.

The People's Bank of China (PBoC) raised its reserve ratio yet again on Saturday, trying to control surging credit expansion and inflation. They upped it by 0.50% to 13% - the eighth such move this year and the thirteenth in a tightening cycle that started four years ago. Clearly, their determination to tighten money has become significantly more forceful recently. The chart below chronicles their moves since 2004.

We can immediately see the genesis-point of today's Chinese bubble: the two year period between 2004 and 2006 when PBoC maintained very low interest rates and reserve requirements. Cheap money resulted in massive capital investment, sucking in huge quantities of raw materials and further boosting cheap exports to the US, which was itself going through a rapid real estate, credit and consumer expansion. The dollar-yuan peg and low Chinese rates made US borrowing from China easier, to finance a ballooning trade deficit.

But PBoC is now moving in the exact opposite direction from the Fed: they are tightening, while the Fed is easing. Unless the US can rapidly increase its own saving rate to provide more domestic credit to the economy, borrowing from abroad is going to get less available and more expensive. And this at a time when the mortgage and LBO debt markets are themselves contracting.

This is the real news...the SIV to end all SIVs is public relations.