The face of the river, in time, became a wonderful book . . . which told its mind to me without reserve, delivering its most cherished secrets as clearly as if it had uttered them with a voice.
-- Mark Twain
Happy New Year! It has been far too long since I’ve posted – apologies to all. The Paper Boat set out for a leisurely float about the harbor one sunny day in August, when it just disappeared. Some folks say something dark lay beneath the ocean’s glassy surface that day, and the boat was pulled down. Some say it wandered too far from charted waters and was lost at sea, surfing the edge of the world before succumbing to the insidious grip of the mighty Kraken. But news has just come in that our sturdy vessel has survived! It has been spotted skipping waves amongst the trusted pages of Forbes Magazine!
Origami from single sheet of paper, Peabody Essex Museum, MA.
In his recent article at Forbes, Big Banks and Derivatives: Why Another Financial Crisis Is Inevitable, Steve Denning cites research from earlier post The Derivatives Time Bomb here at The Paper Boat. He agrees that the derivatives market is precarious, and goes so far as to declare global financial meltdown is on the way. He reveals that many of the banks considered the safest today are actually at great risk due to derivatives transactions hiding beneath benign sounding labels. Wells Fargo, for example, shows activity it calls “customer accommodations” on its books with a notional risk totaling two trillion dollars. This vast allocation of funds is actually invested in derivatives arguably no safer than bets placed at a casino. Other banks are in far deeper. JP Morgan showed a notional amount of $72 trillion on its books at the end of the third quarter of 2012. As Denning points out, “that’s five times the size of the US economy, or about the same size as the world economy.”
Another shocking revelation Denning provides is a look into the use of off-balance-sheet accounting devices, such as “variable interest entities” (VIEs), at veritably every major bank. These are basically no different from the “special-purpose entities” used by Enron to hide its debt. What’s worse is banks exclude some of these VIEs from consideration altogether, in the same way and for the same reasons that Enron excluded its special-purpose entities, claiming their involvement is insignificant or temporary, or that they do not operate the deals. The opacity under which bank funds are managed on the micro level seems to be just as dense as that under which the derivatives market operates on the macro. Considering the unfathomable monetary numbers involved across the board, this is not good news. It seems the global system may indeed be at risk of collapse.
Forbes Big Banks and Derivatives: Why Another Financial Crisis Is Inevitable
January 8, 2013 http://www.forbes.com
A consensus seems to have formed in the press lately that the housing market has finally turned around and we are at last back in bull territory. I tend to believe that such analysis is in bull territory, the sort of bull territory you wouldn’t want to get your foot stuck in as you scramble across the pasture. We may have already witnessed the most precarious price plunges in housing, but expect to see continued decline regionally, especially at the mid-to-high end of the market.
Be very careful when listening to reports about the economy in the mainstream media. Even trusted institutions such as National Public Radio are prone to unfounded cheerleading for the recovery these days. I was dismayed to hear senior economist Mark Vittner of Wells Fargo spewing blatantly false information on the health of housing on Marketplace Morning Report recently.
“The actual low in home prices is behind us, and it is behind us in virtually every part of the United States,” Vittner boldly asserted.
Sadly, Mr. Vitner’s statement indicates a complete lack of understanding regarding the fundamentals moving the housing market as well as the economy at large. The Marketplace report focussed on foreclosures, reporting in the most unspecific way that while foreclosure “activity” rose in June it was down on a year-to-year basis. The reporter then went on to conclude ”… as the inventory of foreclosed properties goes down, housing prices should continue to go up.”
Uh… WRONG… on two fronts. First, the number of foreclosure starts is not decreasing, so inventory is still accumulating. Secondly, the shadow inventory of properties already in foreclosure that has yet to hit the market is massive and will continue to depress prices.
While actual bank repossessions of property (REOs) have decreased recently, there has been a steady increase in the number of properties entering the foreclosure pipeline. Filings of initial notices of default have increased on an annual basis for three months in a row! The number of homes falling into repossession has slowed only because banks put the repo process on hold while awaiting a major federal ruling against mortgage providers. At the same time, banks increased their use of short sales to clear inventory. A short sale allows the distressed owner to sell at a steep discount in order to avoid bank repossession of property, but it results in the same downward pressure on market prices that a repo would.
“Lenders are much less likely now than they were even a year ago or two years ago to repossess a property after they’ve started the foreclosure process,” says Daren Blomquist, a vice president at RealtyTrac. ”Completing the foreclosure process can potentially open banks up to liability if they’re accused of improper procedures.”
It is estimated that as much as 90% of foreclosed property is still in the shadows. I recently did a spot inventory check on Woodland Hills, a mid-to-higher priced suburban area near to where I live in Los Angeles. I found over four times the number of properties in the foreclosure pipeline as are actually listed for sale there. Woodland Hills is a desirable middle class area with good public schools and a median income considerably higher than that of the greater Los Angeles area. It is a good example of a mid-to-high tier market that has yet to fully realize losses in property values.
While California posted the nation’s highest foreclosure rate last month, the process here is relatively streamlined and quick. Many other states, like New York, require foreclosures to be approved through the court system. This means the foreclosure process is vastly slower in New York than in areas without such restrictions, like California. As a result, in New York there are enough foreclosures still waiting to be processed to keep the courts busy for the next 57 years! The problem is so horrendous, an unprecedented initiative was established earlier this year to allow the state to create new foreclosure courts dedicated solely to handling the mess. New York, New Jersey, Florida and the many other states where foreclosures are processed through the courts are facing massive losses in property value ahead.
Foreclosures are just one force affecting housing prices. There are many other variables indicating that housing will remain in the doldrums for some time to come. Even if we do see a bottom in prices, we will certainly not see a sustainable rise in values any time soon. Some of the other factors pushing prices down are continued high unemployment, massive numbers of underwater mortgages, shifting social demographics, psychological pressures and weakness in the national and global economies.
Unemployment will continue to keep people out of the housing market. People don’t buy homes when they don’t have jobs. Not only are unemployment numbers high, but those who do find work are getting lower paying jobs than they had in the past. Many of those folks who managed to avoid unemployment during the recession have seen their wages and benefits cut. People are making less money and therefore have less to spend. There is also a strong psychological effect of high unemployment. People are just less willing to commit to large purchases as they worry about the security of their future income streams.
There are large numbers of homeowners underwater on their mortgages in today’s market, and as prices continue to fall more slip into the danger zone. A mortgage is underwater when the holder owes more on the loan than the property will currently sell for. Evidence shows that people are much more likely to cease payment and walk away from their homes under such conditions. In fact, we have record numbers of folks doing just that. These properties will continue to add to foreclosure inventory, and in turn that will push prices down further in a vicious deflationary cycle. Government stimulus and the promise of loan modification have stalled the speed of this deflationary cycle, but these are temporary patches and will not stop the bleeding.
Demographics play a role in determining the direction of housing prices, as well. As the huge baby boomer generation heads into retirement, many will hope to sell their homes. They’ll want to downsize as their children leave home, or supplement their generally poorly funded retirement savings. But who can afford to buy these houses at current prices? Certainly not the upcoming generation of younger Americans. The younger people that would normally have taken that role are not only a much smaller group in number, but they are experiencing depression level unemployment and debilitating college debt that leave them unable to afford homes at current prices. They have also grown up seeing the losses their parents experienced in real estate and are not particularly eager to buy property. The health of real estate depends on first time buyers, and today there are few.
Psychology is often ignored by economists, but behavioral economist Robert Shiller at Yale University who co-created the famous Case-Shiller housing index believes it is one of the most influential factors determining the direction of the housing market. I would agree. Long term momentum keeps prices heading in the same direction despite shifts in fundamentals. When people saw the kind of money others were making in real estate during the bubble years it kept them buying and driving up prices even when fundamentals were totally out of whack. This phenomenon is called a “feedback loop.” Feedback loops become stores of psychological energy that drive the market further along in the direction it is already going. They work on the way down as well as the way up. For this reason, we can see that historically markets tend to overshoot to the downside after a bubble collapses. We have not yet seen any kind of overshoot to the downside in housing prices. This would imply there may be discounts ahead.
On a global level we are seeing all kinds of fraudulent banking behavior. There is a huge potential for something to go awry in the derivatives market. The LIBOR rigging scandal shows there is no way to meaningfully assess the market value of just about anything. Europe is pretending to have a solution to its problems when there is none. Manufacturing is down worldwide. Public pensions everywhere are headed for collapse. The threat of major warfare continues to loom. We are in the midst of a global economic crisis. Uncertainty is extreme. In the short run US bonds look comparatively good, but none of this bodes well for the US economy in the long run. What is bad for the US economy is bad for the US housing market.
I am putting my money on the likelihood we are in for further declines in housing prices in many areas of the United States. Don’t step in the housing bull crap.
Indianapolis Business Journal National, State Foreclosure Starts On The Rise
August 9, 2012 http://www.ibj.com
Wall Street Journal Is This The End Of The Housing Bust? Not So Fast, Says Shiller
August 6, 2012 http://blogs.wsj.com
AOL Real Estate Shadow REO: As Many As 90% Of Foreclosed Properties Held Off Market
July 13, 2012 http://realestate.aol.com
We need to talk about derivatives. The market has grown so unfathomably vast, the global economy is at risk of massive damage should even a small percentage of contracts go sour. Its size and potential influence are difficult just to comprehend, let alone assess. It is imperative, however, that we begin to understand derivatives, as they were at the heart of the housing bubble that brought the economy to its knees and they remain a looming danger in the world economy today.
The shocking truth is that there has been no effective regulation of derivatives put into place since they brought about financial collapse five years ago. Even more shocking is that the size of the derivatives market has exploded since that time. The total notional value, or face value, of the global derivatives market when the housing bubble popped in 2007 stood at around $500 trillion. New numbers from the Bank for International Settlements (BIS), which tracks the sales of derivatives, shows the Over-The-Counter derivatives market alone has grown to a notional value of at least $648 trillion as of the end of 2011. However, according to the best estimate of the International Swaps and Derivatives Association (ISDA) the BIS numbers are understated and the market is likely worth closer to $707 trillion and perhaps more.
Now, if you’re not a number junkie type – which I really am not – you can guess seven hundred trillion dollars is a pretty serious amount of money, but you might not completely understand the totally astronomic scale that number represents. To put it into perspective, we should note that the gross domestic product of the entire world stands at around just 60 trillion dollars. The US residential real estate market is worth 23 trillion dollars. The total value of all the US stock markets is a mere 16 trillion dollars. The value of the entire world’s stock markets is about 50 trillion dollars. Derivatives currently represent around ninety percent of the world’s financial liquidity. Unfortunately, in addition to remaining vastly unregulated and opaque, the market for the creation and exchange of derivative contracts operates much like the roulette wheel at a Las Vegas casino.
Derivatives have become instruments that enable banks to gamble with vast amounts of money in order to produce high returns on their investments. A derivative is essentially a bet. They were used responsibly in business for centuries as insurance against loss. For example, in a simple derivative contract a farmer might bet against the success of his own crop to insure that if his crop fails he will not be at a total loss. If the crop is productive that year, he loses the bet but reaps a profit from sale of his product. If the crop fails, on the other hand, he can collect on the bet and make up for his loss of profit. Derivatives provide a way to produce even returns in markets that are subject to uneven productivity.
One of the problems with today’s derivatives market is that it has expanded from its initial purpose of hedging and simple speculation to allow for betting on just about anything financial. During the housing bubble we saw banks like Goldman Sachs betting on the failure of the very products they were selling as “AAA” rated safe investments. They made a ton of money on the failure of their own financial products in this way. (Talk about conflict of interest and moral hazard!) Today’s synthetic derivatives market even allows for betting on other people’s bets. This has created a multi level ponzi scheme of derivatives that are based on the success of other derivatives, using huge degrees of leverage at every layer. Today, when a farmer bets against his crop, banks and hedge funds pounce on the opportunity to bet on the success of that farmer’s derivative contract, and then other bets are placed on the success of those bets and so on. With each bet using leverage to inflate the face value of the contract, we end up with multiple bets that have a combined value exceeding the actual value of the farmer’s crop many times over.
Another problem with today’s derivatives market is that the contracts are so loosely controlled that no one is really sure of the actual numbers concerning its size or structure. Our government has colluded with Wall Street and the banking industry to ensure there is no central clearing house for derivative transactions, no central reporting and no disclosure. There is one arm of derivatives sales that does work through clearing houses which record and track transactions, but since the $700 trillion dollar Over-The-Counter (OTC) arm of the market remains unregulated and opaque, an accurate assessment of risk is very difficult to make.
The combined exposure of the nine biggest banks involved in trading derivatives comes in at $228.72 trillion. These are JP Morgan Chase, Citibank, Bank of America, Goldman Sachs, HSBC, Wells Fargo, Morgan Stanley, State Street Financial and Bank of New York Mellon. To get a sense of the scope of the derivatives bubble, check out an excellent visual depiction at Demonocracy.info. Keep in mind when considering the graphics, this number reflects just a third of the total notional value of the global OTC derivatives market.
Warren Buffet called derivatives “financial weapons of mass destruction.” Brooksley Born, former head of the Commodity Futures Trading Commission, warned of serious economic chaos due to the continued lack of transparency, regulation and basic understanding of the market. Author and ex-Goldman Sachs insider Nomi Prins warns the banking system is vastly over leveraged and at great risk due to colossal exposure to derivatives. We are already suffering the effects of a collapse in the derivatives ponzi scheme that almost destroyed the US economy and wreaked havoc across the globe in 2007. Today we face the possibility of another collapse that could be far worse. We recently saw the collapse of MF Global and a two billion dollar loss at JP Morgan Chase, both of which were essentially the result of bad bets in the synthetic derivatives market. These losses only barely represent the tip of the iceberg.
Meanwhile, Treasury Secretary Timothy Geithner continues to make it a priority to keep the derivatives market growing. Basically, there is no other game in town to realize the kind of profits banks and their clients demand these days, so the roulette table is the place to be. As top deputy to former Treasury Secretary Robert Rubin, Geithner opposed Brooksley Born when she warned of the dangers of derivatives way back in 1998. Born wanted to create regulations requiring transparency and oversight of the derivatives market, but was viciously blocked by the Treasury Department and then Fed Chairman Allen Greenspan. Ten years later the lid blew off the ponzi scheme and Born’s anxieties were realized. The housing market collapsed, bringing the world economy down with it.
More recently, as Secretary of the Treasury to the Obama Administration, Timothy Geithner repeatedly opposed and blocked the efforts of Born’s successor as CFTC Chairman, Gary Gensler, to toughen scrutiny of the derivatives market. The result is that the market that took down the economy has grown even larger since that disaster. Wall Street merely left the housing market behind and started betting more furiously on other things, like the failure of the Greek economy, the portfolios of maverick financial traders and who knows what else.
We are facing a ticking time bomb. The global derivatives situation today is very frightening indeed, but information is power. I will continue to explore the subject in more detail here at The Paper Boat. Meanwhile, I’ll leave you with this short video series from Harvard Law School Professor and Managing Principal of Cambridge Meridian Group Inc, Jack McMullen. He offers a very good explanation of the derivatives market and wherein the problems lie.
Casino Royale: Derivatives and the Financial Meltdown, part 1
Casino Royale: Derivatives and the Financial Meltdown, part 2
Last week Spanish Prime Minister, Mariano Rajoy, warned “Spain is facing an economic situation of extreme difficulty – I repeat: of extreme difficulty – and anyone who doesn’t understand that is fooling themselves.” When the Prime Minister is willing to admit the state of affairs is extreme, we’d better take heed.
As usual, here in the US we see little economic reality addressed in the evening news and have heard almost nothing about how very close to the economic abyss Spain is teetering. The situation in that country is dire. Spain is in a serious and deepening financial depression. Unemployment is up for the eighth consecutive month, as it approaches the 25% mark. The economy is contracting, with falling revenues and industrial output. The country has been wracked with strikes and massive violent protests as austerity measures cripple the financial stability of the populace.
Unfortunately, more devastation is to come. I ran across some amazing statistics from Mike Shedlock last week that show the majority of the Spanish budget is dedicated to pensions, unemployment and interest… 57%, to be precise. Amazing… and totally unsustainable. Especially when we consider both unemployment and interest rates are only heading higher. There are going to be major cuts to pensions. What will happen then? The people have already taken to the streets. We are going to see more protests and more violence. The economy cannot sustain further cuts without creating worse financial damage, as well as serious sociopolitical consequences.
Another shocking illustration of Spain’s proximity to disaster shows up in the story of its bond market. Last week an auction of 5-year treasuries sold a billion euros short of target. Yields were off a full percentage point on a month-over-month basis. While the previous month’s auction put the Spanish bond rate at 3.3%, this month’s auction saw bond yields increase to 4.8%. This is after the LTRO 2 (second Long Term Repo Operation by the European Central Bank) injection of an estimated one trillion euros. Five years ago we’d have expected that kind of money to fund a 2 to 3 year new business cycle, but today it just disappeared over the course of a few months into the massive financial black hole Spain has become. Banks will likely soon find themselves underwater on Spanish bonds they bought with bailout money that was given to them in order to bail them out from prior bad investment decisions. Of course that will soon put them in need of… another bailout! As we look at multiple layers of failed bailouts, we have to ask if the emperor is wearing any clothes.
Yet, another bailout seems inevitable because at the base level we are talking about peoples’ lives and survival. Spain will have to seek international funding. The people cannot sustain anymore austerity cuts without severe and even lethal consequences. Which brings up another piece of clear and validating evidence the country is indeed in deep trouble: the official denial of such trouble. The Spanish Economy Minister just released this official statement: “any suggestion that Madrid needs emergency international funds is absurd.” There is no better indication of real trouble than an official denial by government that such trouble exists. The Ministry of Truth has declared there is nothing to worry about, so you’d better worry. The Econ Minister probably should have met with the Prime Minister before going on record like that, just to get their story straight, ya’ know? Either way, Spain is going to implode.