Sunday, March 18, 2007

The Infallibility of Alan Greenspan

The tragedy (other than how Fed decisions affect most of us, of course) is that Greenspan was unusually competent for this Administration, which, of corse, is not saying very much. And damns with faint praise.

But here I learn that the regual author of this column (one of the inventors of snarkiness, actually) is neighbor and he goes and skips this week.

Nonetheless, from that well known Marxist economic journal, Barron's, a slice and dice of Greenie:

WHEN ALAN GREENSPAN FIRED OFF HIS RECESSION forecast heard 'round the world a couple of weeks ago, he delivered it to an audience of investors in Hong Kong via a video linkup from halfway around the world. Could it be that the former Federal Reserve Chairman might not feel so cozy and secure in Asia, given what's befallen ex-central bankers in the region?

Back in 2005, the former Thai central bank governor was fined $4.6 billion for his role in the financial crisis resulting from the crash of the baht. Rerngchai Marakanond was found by a civil court to be guilty of "grave negligence" in squandering Thailand's currency reserves in a futile attempt to prop up the baht.

The 1997 Asian currency crisis also led to the arrest of Korea's central bank governor at the time, Kang Kyong Shik, for "gross economic negligence." He was imprisoned for three months in 1998, while awaiting trial. Prosecutors made Kang appear in court in prison garb, handcuffed and in ropes, adding to his humiliation.

As Dresdner Kleinwort's global strategist Albert Edwards, once wrote, if central bank chiefs are to be held accountable for negligence, should Greenspan be worried?

That question was raised anew as the bubbling subprime mortgage crisis erupted last week. As several acerbic observers pointed out, there could be no more damning indictment of Sir Alan's role than his own words.

In a speech to the Fed's Community Affairs Research conference in April 2005, The Maestro sang the praises of "technological advances" that "have resulted in increased efficiency and scale within the financial services industry. Innovation has brought about a multitude of new products, such as subprime loans," he continued, adding that technology had allowed lenders to size up the creditworthiness of borrowers more cheaply.

"Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today, subprime mortgages account for roughly 10% of the number of all mortgages outstanding, up from just 1% or 2% in the early 1990s."

Since then, subprime mortgages have burgeoned to about twice that level, to around 20% of the total, according to most estimates. And the results are becoming apparent. The purveyors of subprime loans are dropping like flies (having had a comparable lifespan) and delinquencies are soaring, even among the most newly minted loans.

In past cycles, iffy loans would take a few years to season and then sour. This time around, subprime loans are going bust almost before the ink is dry -- notwithstanding all the new and improved means to size up potential borrowers. It seems that an even older principle of technology is at work -- GIGO -- garbage in, garbage out. No verification of income or assets, fantasy appraisals -- all crunched quickly and at low cost.

Yet among the avalanche of coverage of the subprime debacle, the deterioration of adjustable-rate mortgages -- even of prime quality -- is still more dramatic. But three years ago, Greenspan was touting ARMs for Everyman. "American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage," he told the Credit Union National Association in 2004. "To the degree that households are driven by fears of payment shocks, but are willing to manage their own interest-rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home."

As Greenspan spoke, the Fed's key interest-rate target, the overnight federal-funds rate, stood at a mere 1%. Just over four months later, however, the Fed began tightening its monetary policy, eventually raising the funds rate 17 times, to the current 5¼% level.

The impact on those who took Mr. G's advice has been dramatic. The latest data from the Mortgage Bankers Association show a sharp jump in delinquencies and foreclosures in the fourth quarter. People with ARMs with low "teaser rates" at the beginning are getting into trouble once they adjust up to prevailing market rates.

According to Goldman Sachs' chief domestic economist, Jan Hatzius, ARMs that aren't subprime are going down the tube even faster than riskier loans. Prime ARM delinquencies are comparable to their worst level of the 2001 recession, he points out. In contrast, fixed-rate subprime delinquencies are well below their recession levels.

The jump in adjustable-rate mortgage delinquencies is of particular concern in that more of these loans will reset in 2007, some $400 billion worth, write Robert E. Blake and Matthew Moore of Banc of America Securities. Few of these borrowers are likely to be able to refinance, given the tightening of credit standards, resulting in more defaults, they add. (The primary criterion to qualify for an ARM previously had been a pulse.)

By now, it's evident that the thousands of American homeowners borrowed neither wisely nor well. And that set off the predictable yowls on Capitol Hill last week, with the pursuit of scapegoats and calls to make feckless borrowers whole (in time for the 2008 elections, naturally).

But this latest fiasco goes beyond mortgages. "Subprime is today's dot-com -- the pin that pricks a much larger bubble," writes Steve Roach, Morgan Stanley's chief economist.

Back around the turn of the century, he recalls, optimists denied that there was a bubble, just a bit of irrational exuberance in the Internet pure plays, which accounted for a mere 6% of the total stock market at the end of 1999. "That view turned out to be dead wrong," Roach says. The dot-com bust led to a 49% plunge in the Standard & Poor's 500 and the asset-dependent U.S. economy slipped into a mild recession, dragging the rest of the world along.

"Fast-forward seven years, and the actors have changed, but the plot is strikingly similar," he continues. "This time, it's the U.S. housing bubble that has burst, and the immediate repercussions have been concentrated in a relatively small segment of the market -- subprime mortgage debt.

"As was the case seven years ago, I suspect a powerful dynamic has been set in motion by a small mispriced portion of a major asset class that will have surprisingly broad macro consequences for the U.S. economy as a whole," Roach concludes.

The fear in the financial markets, according to RBC Capital Markets, is that the subprime defaults will lead to a meltdown in the market for collateralized debt obligations, which would trigger a flight to quality that snowballs into an unwinding of the yen-carry trade (and massive mixing of metaphors).

As Jackie Doherty describes in Delinquency Problem, CDOs are derivatives made up of all sorts of debt, including securities backed by subprime mortgages, that are then magically sliced and diced in all manner of wondrous ways by the wizards of Wall Street. The demand for the underlying collateral -- the so-called CDO bid -- has been a major driver in the demand for debt securities.

But if the buyers of CDOs begin to shy away, that will mean less credit for all sorts of things, including the buying binge by private equity. In that regard, according to a posting by Mark McQueen of Wellington Financial on the Seeking Alpha blog, one private-equity shop principal mentioned that the credit market was causing concern as it was trying to line up financing for a deal.

The flight to quality -- a euphemism for panic buying of government notes and dumping of riskier debt and equity -- has waxed and waned, and with it the notorious yen-carry trade. But the causality may run counter to the conventional wisdom.

When the urge to sell erupts -- as when the Chinese stock market took a header a couple of weeks ago -- volatility surges. Under the current modus operandi known as value at risk, or VAR, the jump in volatility results in an immediate reining in of positions. (For oldsters who remember 1987, this sounds more than vaguely reminiscent of portfolio insurance.) In the process, yen borrowings -- taken on at rates reflecting the Bank of Japan's 0.5% benchmark -- get repaid, resulting in a spike in the yen's exchange rate in the currency market. That, in turn, squeezes the vise on those still in the yen-carry trade, begetting more selling.

Lurking in the background of all this is the expectation that Ben Bernanke's Fed will renew the "Greenspan put" -- the ex-Fed head's implicit insurance policy for the financial markets, resulting from his willingness to slash rates to bail them out -- if the supposed doomsday scenario of subprime defaults leading to panic in credit derivatives and a plunge in the dollar versus the yen comes to pass. "As we see it, the problem and the main risk with the U.S. economy is that there is too much credit, not too little," according to the Daily Observations of Bridgewater Associates, one of the biggest and most successful money managers.

As the Federal Open Market Committee convenes this week, the subprime mess no doubt will be a matter of discussion, but don't look for Bernanke & Co. to open the spigots. "In fact, the amount of leverage in the system is a reason for the Fed to lean against the wind and keep rates higher than they would otherwise, unless things begin spinning out of control," the Bridgewater folks write.

"Ultimately, it is up to Ben Bernanke -- and whether he has both the wisdom and courage to break the daisy chain of the 'Greenspan put'," adds Morgan Stanley's Roach.

"If he doesn't, this liquidity-driven era of excesses and imbalances could well go down in history as a huge failure for modern-day central banking."

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