Contagion

Today I saw that Martin Armstrong has dusted off this oft-used word to describe the European debt situation.  Certainly I agree, though Martin made the mistake that most “stock jocks” make — they think the process is some kind of disease that passes through contact rather than a step by step cause-and-effect process that can be stopped, or not, depending on how the market participants, central bankers, lenders, borrowers and politicians behave.

I pulled out my 2008 manuscript again, because the parallels are frightening.  El Erian at Pimco sounded the warning today, that conditions are like 2007/2008 again in many ways.  I think most of us in the global credit markets are getting that feeling these days.

Sadly, the chapter “Contagion” warned that the process of contagion was heading out of the subprime mortgage world when I wrote it in early 2008, and I saw where it was going — straight toward the prime conventional mortgages that Fannie Mae and Freddie Mac guaranteed.  Those firms were very thinly capitalized, and there was no way they could withstand a major loss of equity by their borrowers with their 20% down payment conventional mortgages.

Yes, it happened.  If the Treasury Secretary, the Congress and the Fed had realized that it was impossible to “contain” the problem to just one class of borrowers, maybe they would have tried to address the underlying problem rather than patching and re-patching the lenders and investors with unlimited liquidity, courtesy of the taxpayers.

Having said all that, here’s the chapter of Mortgage Market Mayhem called

Contagion

As the structured finance credit crisis unfolded, two of the most popular words used to describe it were “contagion” and “contained.” Although both these words share the Latin prefix “con,” meaning “with,” the first word was used to throw gasoline on the fire and the second word was used in an attempt to throw water on that same fire.

It was common throughout 2007 to hear business leaders, our Federal Reserve Governor, and a stream of politicians all using the word “contained.” By repeating the mantra “the subprime mortgage problem is contained,” the containment team hoped they could convince the market and the public that it was only those little subprime people who had a problem.

Armed against the containment team were the reporters and hedge fund bears who shouted “contagion” every chance they got.

It was enough to make you wonder if either team knew how the capital markets really work. Both teams’ “analysis” was presented as if they thought that sharing an elevator with a person with poor credit might make a responsible person go home and default on their obligations.

The fact is that simple exposure to subprime borrowers does not make good borrowers turn into bad borrowers. Nor does one investment turn bad just because another does. That kind of contagion is an imaginary malady, like the “humours” doctors thought caused disease before they discovered bacteria.

The containment team looked to all the other classes of debt to assure themselves that credit problems were contained, smugly pointing out that credit card bills, prime mortgages and car loans were still being paid on time. At the same time, the contagion team looked everywhere for evidence that other classes of debt were collapsing.

Meanwhile, the real contagion both should have been worried about was taking hold. The relentless focus in both the financial press and the general press on what they liked to call “the subprime meltdown” was leading investors to do everything they could to avoid any exposure to this sector of the debt market. Some investors automatically sold any bank stocks, any bond portfolio holder, or even commercial paper, if there was any exposure to subprime mortgage debt, no matter how small, and regardless of whether that exposure reflected any genuine risk or not.

Fire sales took place for financial products containing no genuine risk, such as a bond with top priority for payments and a huge percentage of the structured deal subordinated to it. We sometimes see these kinds of bonds with 70% or 80% of the deal in junior positions in a credit “waterfall.”

It’s enlightening to see what happens in a deal such as this when a mortgage loan in the pool is foreclosed. After the house is sold, selling expenses, legal fees, repairs, etc. are repaid to the mortgage Servicer who advanced those costs. Then the proceeds from the sale are forwarded to the Trustee for the securitization. Any loss is recorded as a reduction of principal (“write off”) for the lowest priority bond in the deal structure. Finally, the money that is recovered is used to pay down principal on the highest priority bond. A bond with 80% of the deal subordinated underneath it could withstand having every single house in the mortgage pool foreclosed and sold at a small fraction of its former value. We call these bonds “bullet proof,” because they actually get paid no matter what happens, and they could be paid off even faster if there are more foreclosures.

When investors avoid bonds like these, and force them to be sold for very high spreads, they essentially force every other bond to offer the same or higher spread. This is capital markets contagion, and it has nothing to do with other kinds of debt performing poorly from a credit perspective.

When investors avoid bonds like these, and force them to be sold for very high spreads, they essentially force every other bond to offer the same or higher spread. This is capital markets contagion, and it has nothing to do with other kinds of debt performing poorly from a credit perspective.

Billions of dollars worth of subprime debt was being sold for a song, even the bullet proof stuff. The result was that borrowing became much more expensive both for prime mortgage borrowers and foreign governments. Corporate entities had to borrow operating capital at much higher rates than they would have otherwise.

Tangentially, investors who bought mining company stocks, agricultural companies or fast-growing foreign companies were disappointed by earnings that came in lower than expected. Lower earnings should have been no surprise, given the fact that the asset backed commercial paper programs were among the biggest suppliers of trade financing used to cover the cost of metal ores or agricultural commodities until delivery.

When the market avoided buying that commercial paper, those who relied on that funding had to locate new sources of financing. Many good borrowers in the commodities business had to turn to bank loans for their short-term financing. That was already a more expensive source, but became even more expensive as the banks themselves paid higher spreads due to worries about mortgage exposure.

[Definition] Negative real interest rates –

When short-term rates, or the cost of funds, are lower than the rate of inflation. This policy quickly recapitalizes banks and other lenders by ensuring profits from almost all lending and investment.

Selling good bonds dirt cheap and making all financing too expensive is the result of true contagion. It has been a natural outgrowth of the avoidance of subprime mortgage bonds, no matter what the flavor or concentration. And it makes no more sense than wholesale slaughter of every livestock breed around the world following an outbreak of Avian Flu.

The underlying cause for the eventual collapse of our debt markets was the policy reaction to the first recession of the new millennium – an extraordinary period of negative real interest rates.

We also had nearly unprecedented government spending increases at the same time that government revenues (taxes) were decreased. The net result was huge inflation for assets that could be easily financed and exhaustion of savings to support current spending.

Trusting history, mortgage lenders believed the collateral value of the houses they lent against would not decline in any meaningful way, especially nationwide. The capital markets enabled funding of mortgage loans, even subprime mortgage loans, only thirty to fifty basis points above LIBOR.

With LIBOR as low as 1.10% after the Fed lowered short term rates to 1%, a subprime borrower was paying a full 5% premium above funding costs even after taking expenses into account. Since the prior peak for loss rates on subprime mortgage loans was only 2% to 3% annually or 6% to 7% over the life of the deals, it seemed that there was plenty of cushion against losses.

Homeowners responded to this environment by taking an unprecedented amount of cash out of their homes, either by selling them, or by refinancing. By 2005, “cash out refi’s” were estimated to have added as much as $600 billion a year to the American economy. That was nearly 4% of the economy at the time.

The Federal Government was doing much the same, borrowing about $400 billion a year from Social Security and Medicare payroll taxes to spend on current projects, which was in addition to several hundred billion a year in deficit spending. As a nation and as households, we were trying to borrow our way to prosperity.

At some point, schemes that involve borrowing to support current consumption run out of assets or future income to pledge, or run out of lenders willing to lend. In the case of U.S. housing, both effects combined to help the market “roll over” precipitously.

Effects are often compounded when two unfortunate events occur simultaneously. Virtually all the credit worthy potential home owners (as well as many who weren’t credit worthy) had acquired their first homes. At the same time, the increase in home values came to a halt and this latent source of future income to pay debt service disappeared.

This latent income had actually bailed out many of the subprime borrowers who paid their mortgages, their credit cards and their car loans by taking out cash through refinancings as their home values increased much faster than the rate of inflation.

The open question is to what extent this latent income also made prime and near-prime borrowers appear to be able to handle their debt loads better than their earned income would allow.

The politicians and talking heads that fell into the “contained” camp spent most of 2007 focusing on the good performance numbers for credit card debt, prime mortgages, auto loans, and other debt. They concluded that the rising tide of mortgage delinquencies was limited to the typical subprime borrower, a borrower who lived as little as one or two paychecks away from defaulting on their debts. The “contagion” camp was watching the same statistics, looking for an uptick in problem credits to justify their view of worldwide credit destruction.

For a while, the “contained” camp won the war of ideas, to disastrous effect. Nervous investors believed that if they could only contain the problem, they could preserve the value of their portfolios. So they tried their best to find anything that had any exposure to subprime mortgages. And they sold it at almost any price.

The great portfolio purge had begun. Investors were soon dumping commercial paper from SIV’s that had pools of $400 billion in assets with only 2% to 3% subprime debt. Significantly larger asset classes in those SIV’s were bonds and CD’s sold by insurance companies and banks; prime mortgage investments; CLO’s collateralized by bank loans to speculative corporate credits; and trade financing for commodities like oil, metal ores and agricultural commodities.

Unwittingly, in their rush to avoid subprime mortgages, investors were damaging market sectors that were supposedly insulated from subprime risk. The direct effect of the portfolio purge was to increase costs, cut funding capabilities and reduce profit in other market sectors. While its effect will not be seen for a while, and those commodities businesses are strong, they now have a need for new and more expensive funding for trade finance. This is Stage One of real contagion.

Ironically, the SIV’s that were being forced to shut down only held about $8 billion of the subprime mortgage bond market, or about half a percent of the $1.2 trillion in subprime mortgage funding. When the SIVs sold out of those positions, it made almost no difference to the subprime mortgage bond business.

On the other hand, SIV’s were a huge provider of funds to banks and insurance companies. These institutions scarcely needed additional pressure on their capital bases or cost of borrowing, since they held most of the mortgage debt before the crisis began.

Banks under pressure had no choice but to tighten up on all lending, and to charge higher rates to borrowers. This is Stage Two of real contagion.

House prices were no longer increasing, but decreasing. Many borrowers needed rising house prices to pay their debt service. At the same time, the cost of debt service was going up with increased mortgage rates. The sell off in subprime mortgage bonds accelerated as investors anticipated that foreclosures and the losses on foreclosures would increase.

Some investors decided they couldn’t ignore the attractive values available in residential MBS. However, because investors are nearly always fully invested, they have to sell something in order to buy something else. Selling one type of mortgage bond to buy another is the easiest choice within an institution, so commercial mortgage yield spreads widened dramatically as commercial mortgage bonds were sold so investors could take advantage of great deals in residential mortgage bonds. This is Stage Three of real contagion.

Commercial Mortgage AAA bond index – Source: MarkIt.com (March 2008)

Simultaneously, in 2008, commercial mortgage loans began to lose value, even though commercial properties had not been overbuilt to the same level they had been in prior economic cycles. Professionals in that specialty were dumbfounded, because fundamental credit performance was better than it had ever been. In January of 2008, securitized commercial mortgages recorded their lowest delinquency rate in history.

Even AAA-rated CMBS (commercial mortgage backed securities) were soon trading at 200 to 225 basis point spreads over LIBOR, up from 15 to 25 basis points a year earlier. Spreads for U.S. Government-guaranteed Ginnie Mae MBS and implicitly guaranteed Fannie Mae and Freddie Mac MBS also doubled.

High quality corporate bonds from even top-rated corporations like GE and Berkshire Hathaway were soon trading at around 100 basis points over LIBOR, ten times the spreads they traded at in prior years.

Less credit-worthy corporate borrowers experienced even harsher increases in borrowing costs and terms. The Markit.com chart below shows spreads for an index of 100 issues of high-yield corporate bank loans, loans to the same kind of companies that issue junk bonds.

Even though the subprime “meltdown” was well underway in October of 2007, the average junk bond was only trading around 220 basis points over LIBOR. That changed when the real contagion hit Stage Three, and investors began to sell other kinds of debt to raise money to buy more of the cheap mortgage bonds. The following chart shows the price and the yield spreads of the LCDX index, a proxy for CDS on bank loans for 100 corporate borrowers. Spreads that were around 3% over LIBOR as 2008 opened suddenly went up to 5.2% over LIBOR.

LCDX bond index (corporate credit) – Source:  MarkIt.com (March 2008)

The selling of debt instruments continued as more and more leveraged investors and special purpose vehicles were forcibly unwound.

There were subprime mortgage bonds in the market that would pay full principal and interest even if every single mortgage were foreclosed, and the houses sold for circa-1988 prices. In spite of the virtually risk-free return of all principal and interest on these bonds, they traded in February of 2008 at spreads several hundred basis points over LIBOR.

This led rational investors to conclude that any borrower or debt would have to pay similar yield spreads unless the “bullet proof” mortgage bonds started trading at lower yields and higher prices.

This was the fourth and final stage of contagion, as the capital markets gradually tightened across all debt categories, no matter what the underlying asset or source of funds. The final straw was when subprime mortgage bonds with little or no credit risk could be bought at very high yield spreads, so all the other kinds of debt had to drop in value until they also offered high spreads.

A more insidious contagion has been unleashed as we watch the weakening of the housing and housing finance market in the largest economy in the world.

One thing we can infer from the high credit scores of the alt-A borrowers is that they have more economic lasting power than the lower score subprime borrowers. However, it would be a mistake to assume that they didn’t see the same opportunities and take the same risks as the subprime borrowers did. This has proven to be the case, as we already began seeing higher delinquencies and defaults among pools of alt-A mortgages in the second half of 2007.

In reality, alt-A borrowers are just the next group along the credit spectrum, and they, too were taking equity from their homes to spend, counting on further home price appreciation to fund their activities. The delinquencies and defaults showed up six to eight months later only because the alt-A’s had more financial resources (and therefore more lasting power) than the subprimes.

Actually, it’s all a continuum. Every person and every family in America is constantly doing what they can to manage their cash flow and their obligations, and the results will always vary from those that can never pay all their bills on time to those that never miss a payment, even by a single day.

General economic conditions tend to push more of us up or down the scale. On top of that, at any given time, a decent sized fraction of us are dealing with large financial disruptions or setbacks such as a divorce, a new job, tuition or medical bills, along with a myriad of smaller financial issues.

Lower house prices and poor real estate markets became a nationwide problem in 2007, so even the “prime” borrowers whose loans were the core portfolios of major banks and the housing Agencies Fannie Mae and Freddie Mac were in trouble if they needed to sell their homes or refinance.

Even those prime mortgage loans and mortgage-backed securities became hard to finance by March of 2008. That’s when the Fed stepped in, increasing its lending to nearly $400 billion, making the money available to the banks and directly to Wall Street dealers by resurrecting emergency lending authority not used since the Great Depression.

Just a month later, in April of 2008, the effects of Stage Four of the bond market contagion struck the student loan market like a violent windstorm. Like the mortgage market, the majority of student loans are made with government guarantees. Millions of families relied on these private loans to make up the gap between the government loans and the cost of college education.

Those loans had been securitized, just like mortgages, into asset-backed securities (ABS) and a market existed in both government-guaranteed student loan ABS and “private label” student loan ABS. When these ABS could only be sold at wide spreads after the contagion events of 2007, lenders were losing money on every loan. Dozens of banks had dropped out of the federal program by April of 2008. Virtually no lender would make the private loans, either.

By the middle of April, 2008, Congress was holding hearings to determine what sort of emergency action could be taken to bail out banks that were deserting the business of student lending, even with a government guarantee.

The open question is whether the extraordinary injection of liquidity into the bond markets by the Federal Reserve and the European central banks will be enough to keep the process of contagion from going on to Stage Five. With $4 trillion in Agency MBS outstanding, the answer isn’t clear.

What is clear is that if borrowing becomes too difficult and expensive for Americans who want housing, cars, appliances, college educations, boats, and all the other things American consumers buy on credit, then all those businesses will have to shrink. If all those businesses shrink, then no one will want to lend to the companies devoted to those businesses. Since Americans buy almost everything on credit, most of the businesses in America will be in trouble. And that’s a dire scenario, except for those positioned to profit from others’ losses.
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I hope you all enjoyed this chapter from my book.  As George and I struggle toward a publishable product on our manuscript, I think I may avail myself of the publishing alternative we choose, and make Mortgage Market Mayhem available to the reading public.

I’m still undecided about updating it throughout to address the (predicted) next steps and their effects.  Maybe that will be the topic of the next book — how to clean up this mess, and get the private financing business working again.

That’s probably a book-length topic all by itself.

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2 Responses to Contagion

  1. David Ericson says:

    As you know, Howard, George (Urban Survival/Peoplenomics) and HPH are now focused on deflation — especially debt deflation — as are you in this well-articulated and argued perspective on our past and present predicament. However, the Fed, if it chooses, can always defeat all kinds of deflation with the printing press over time. George has been spot on in showcasing money (de)velocity and FED M1, M2, M3 rapid increases as measures of the struggle between deflation and inflation in recent times.

    Without constraint of a gold standard,and with a fiat money situation world-wide (currencies race to the bottom), and with a US $ reserve currency (and US need to devalue to repay debt, not to mention the deflationary housing drag), there is no doubt what the Fed will have to do. It will “ease,” and probably overshoot into hyperinflation with the printing press — unless Bernanke lapses into a coma. The markets went into a tantrum yesterday and today, since they didn’t get the easing (not to mention reports of China slowing and European self-immolation). But eventually Bernanke will have to deliver.

    With a fiat money system, no gold standard, and no Volcker (but a Helicopter Ben), real deflation is impossible (except for a transient period). Yes, we will have parts of the economy down — housing down deep — but get ready for the ride up hugely in food stuff, gold, and (perhaps) oil, not to mention stocks when hyperinflation rocks.

    Best,

    David

  2. Taymere says:

    Most excellent, thanks for publishing that. It gives me a thumbnail sketch of what will happen when Greece defaults.

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