Subprime Fiasco Looking more like a Financial Black Swan

Roubani. Potentially already $500 billion in losses (and climbing) as the damage in confidence cuts across the entire financial industry.

The amount of losses that financial institutions have already recognized - $20 billion – is just the very tip of the iceberg of much larger losses that will end up in the hundreds of billions of dollars. At stake – in subprime alone – is about a trillion of sub-prime related RMBS and hundreds of billions of mortgage related CDOs. But calling this crisis a sub-prime meltdown is ludicrous as by now the contagion has seriously spread to near prime and prime mortgages. And it is spreading to subprime and near prime credit cards and auto loans where deliquencies are rising and will sharply rise further in the year ahead. And it is spreading to every corner of the securitized financial system that is either frozen or on the way to freeze: CDOs issuance is near dead; the LBO market – and the related leveraged loans market – is piling deals that have been postponed, restructured or cancelled; the liquidity squeeze in the interbank market – especially at the one month to three months maturities - is continuing; the losses that banks and investment banks will experience in the next few quarters will erode their Tier 1 capital ratio; the ABCP and related SIV sectors are near dead and unraveling; and since the Super-conduit will flop the only options are those of bringing those SIV assets on balance sheet (with significant capital and liquidity effects) or sell them at a large loss; similar problems and crunches are emerging in the CLO, CMO and CMBS markets; junk bonds spreads are widening and corporate default rates will soon start to rise. Every corner of the securitization world is now under severe stress, including so called highly rated and “safe” (AAA and AA) securities.

Comments

[Flagg]

This "collateral crisis" could turn into a full-blown credit crisis very quickly.

Let's just consider one tiny slice of a potential collapse in the ABS markets - PayPal. PayPal, the backbone of many internet commerce sites, offers a high return on its money-market fund that houses most of the "cash" sitting around for eBay and all the other transactions that flow through it. A portion of this high return comes from ABS securities. If those securities go into default or are marked down to market levels, imagine the trainwreck that would ensue. If they have to price the money market fund below a dollar or have to suspend redemptions and purchases... Hello Black Swan city.

[Fabius Maximus]

A black swan is a low probability, high impact scenario -- that is unexpected. The housing downcycle meets only 2 of these criteria.

A large decline in home prices would just return them to the normal trendline, hence this is a normal cycle. This has been widely predicted for several years.

The odd part is that such a normal event, the inevitable downcycle following the massive up cycle, shold have been widely derired as unlikely or impossible. This suggests not that this is a Black Swan event, but that our financial institutions are broken. As if our farmers were astonished and unprepared for winter.

[Tangurena]

Like Fabius, I disagree that this is a black swan. This is more like the dotBomb which followed the dotBoom. You know it is time to bail out when the participants say things like "we're in a new economy/industry/world now, and the old rules no longer apply." Oh, wow, winter, now who could have seen that coming?

The market is seizing up because purchasers are unable to determine good from bad in this environment. In an environment where opacity prevents participants from determining what's good vs what's bad, the smart money leaves. And the opacity came because our country has been destroying and perverting the feedback loops that would have made this bubble impossible to get out of control.

I expect that we're going to see a resurgence of regulation in the financial industry to prevent this sort of thing from happening in the future. I also suspect that we're going to hear a lot more about the off-books SIVs that will remind far too many people about Enron's "special purpose entities."

[dano]

There have always been cycles in US real estate. But never has there been a downcycle of this magnitude and geographic spread. So by definition this is a low probability event. And, since there has never been an event in which the financial instruments affected were so pervasively spread throughout the entire financial marketplace, that furthers the low probability as well as the high impact of this event. Furthermore, if housing prices are to drop simply to the trendline then the decrease in value is the largest drop in value since (and including) the early 1980s bust. This bubble has lasted longer and gone up higher and is geographically and financially broader than any that preceded it. A "correction" will potentially have far greater effects than any since the Great Depression.

So we are looking at a first-time event of unprecedented scale and never-seen-before magnitude. Looks like a Black Swan to me.

Also, this event is not quite comparable to the dot com bust because that - while spectacular (especially for those of us who work(ed) inside that particular bubble and saw it close up - did not affect as many people as this one, nor as dramatically. For the people directly affected then, many lost a lot of money on paper, but they knew exactly what they were losing and exactly the rate they were losing it. In this event, many people are losing their homes, and many investing institutions around the world know only that they hold financial instruments that are affected but they don't know how much or how fast. Financial managers hate one thing above all, and that is uncertainty.

I agree with Tangurena that part of the reason this is happening is due to the opacity of this marketplace, which is partly due to the lack of regulation. (Free markets are good! Let the market adjust itself!) I can't agree nor disagree with the supposition that this will result in increased regulation. I'd like to see some evidence to back that up in this era of free-marketeers (Bush, Chris Cox, et al). We really didn't see much more regulation after Enron or Worldcom, and those were considered rogue operators who by definition evince regulation. This event is being played by an orchestra and conductors that are totally Wall Street and Washington operators, and they don't seem willing to consider allowing any regulation of themselves.

[dano]

Oh and, two more things:

1. Many homeowners withdrew a lot of money from their paper equity in the form of home equity loans. If their home value drops (readjusts, whatever), that is real money that they have to pay back. But how many of them withdrew that to simply make house payments or to maintain status quo in life?

2. The building industry and construction trades have a long ways to fall too. That will affect broader sectors of consumer and financial markets.

[Adam D. Schneider]

Black swan is the new hipster buzzword, I guess. Most people conveniently gloss over the "unexpected" aspect of Taleb's formulation (and if someone used this term before him, I am not aware of it). The very fact that we are "looking at" this event makes it not a black swan.

[Flagg]

QUOTE: Black swan is the new hipster buzzword, I guess. Most people conveniently gloss over the "unexpected" aspect of Taleb's formulation (and if someone used this term before him, I am not aware of it). The very fact that we are "looking at" this event makes it not a black swan. UNQUOTE

It's not the real estate downturn that is the issue - it is the "unknown unknowns" out there that are causing the worry about asymmetric market events.

Having a few Bearn Stearns hedgies go down in flames might be an expected, or at least not too surprising, event in a serious real estate downturn - especially one that is the worst since the Great Depression in terms of geographic reach. But the meltdown in CDO's, ABS paper, etc., are affecting everything from interbank lending spreads to local governments that invested in "AAA securities" that have turned out to be illiquid trash to the rapidly tightening credit market that is going to only add fuel to the fire of an already weak and overbuilt residential property market.

For other casualties outside of the typical real estate investment complex, look no further than E-Trade. An online brokerage that dabbled in mortgages and is now facing bankruptcy. Not a normal correlation. Maybe using the term "black swan" is going a bit too far, but lot's and lot's of "smart money" was and is completely unprepared for this mess that is unfolding.

It's the markets or securities not normally correlated to real estate that will be the source of the surprises to come (hence the throwaway example of the PayPal money market fund as a potential victim, which I glibly tossed out in earlier comments).

Opacity is a great term for a big part of the problems that, at the moment, can't be quantified. But let's not forget that the "free market in real estate" hasn't been "free" for over 70 years - it has been distorted by government mandates, Fannie Mae, rent control, Freddie Mac, the S&L debacle, preferential tax treatments, etc. for decades - so calling for more government to "help" will only make the potential "unintended consequences" mushroom into a full-blown credit crunch. Plus, banks have been able to skirt the spirit of the laws by dumping a lot of this risk off-balance-sheet onto these SIV creatures as a way of gaming government regs as well.

In the end, we will see a lot of folks go to prison and a lot of new regs that will firmly shut the barn door long after the horse has bolted. Depending on how stupid Congress and the Executive branch gets, it could be a generation before the real estate and credit markets recover (in my opinion).

[Adam D. Schneider]

I agree that the magnitude of the problem has yet to fully reveal itself, but correct me if I am wrong (and it has been a while since I read Fooled By Randomness, so I might be), but a black swan should be: 1.) sudden, 2.) large, 3.) unpredictable. Shifting the emphasis from the event of the subprime crunch itself to its effects on other financial sectors adds a bit of #3 back into the equation, but it still seems to be missing #1. Conventional wisdom now seems to be that it's going to be bad, but the whole thing seems to be playing out in slow motion. Regardless of terminology (I posted only because I object to John's overly liberal use of the term black swan), we all know something bad is on the way. How bad is not yet clear, and that's the scary part. Financial professionals aren't the only ones who dislike uncertainty.

[gmoke]

The subprime fiasco was a clear result of a long-term plan by Republicans and conservatives to repeal the New Deal. They've been able to eliminate many of the financial safeguards that FDR put in place and they did it deliberately with malice aforethought. This has been building since the first Reagan administration. Nobody with any sense can say it hasn't been expected.

Again, nobody with any sense can say Peak OIl hasn't been expected either but it has also arrived with nary a peep from the chattering classes. In the last couple of weeks, I've asked Maureen Dowd, Dana Priest, and Mark McKinnon about the possibility of Peak OIl and the evidence that it has already occurred. All three punted. None addressed the issue.

Peak Oil plus housing bubble popped plus massive foreign debt plus the end of the dollar as a reserve currency equals a black swan event of massive proportions.

Guess the Repubs and conservs will get what they want, a new deflationary spiral leading to another Great Depression. Maybe then they'll be able to get rid of Social Security and Medicaid too then, another set of long term goals.

[Flagg]

This is an example of what I was worrying about above, except it was a big-name brand money market fund that broke first:

http://www.reuters.com/article/marketsNews/idUKN1424349720071115?rpc=44

[Tangurena]

>But never has there been a downcycle of this magnitude and geographic spread.

I disagree. The neighborhood I live in (in Denver) was hit hard by the combination of the oil bust and S&L meltdown in the 80s. Many of the homes lost around 80% of their "value" and took until 2000 to recover in price. The S&Ls tried to keep stuff off the market to preserve prices until the financial institutions ended up in liquidation themselves - dumping large numbers of vacant bank-owned properties (called REO) on the market

If we see a financial institution go into liquidation like the S&Ls, and they are somehow unable to keep the large stocks of REO off the market, then we'll start to see large meltdowns in the 70-80% range. For some neighborhoods, that will put them at around 2000-2001 prices. I am waiting for that kind of blood in the streets before I buy.

>So we are looking at a first-time event of unprecedented scale and never-seen-before magnitude.

I disagree. Any market with 30+% annual increases in "price" is a bubble. And that is what real estate has been doing since about 2002. Not every part of the US has had that sort of inflation in real estate prices, but enough has that they drew enormous numbers of scam artists out of the woodwork.

And another part of the fiasco that hit the fan recently is the sloppy paperwork behind the scenes. Deutsche Bank just got spanked by a judge in Ohio for essentially not bothering to prove that they were the mortgage holders in the foreclosure action.

The money quote from the NY Times article is
>But the inability of Deutsche Bank, as trustee for the pools, to produce proof of ownership at the time of the foreclosures will fuel borrowers' concerns that they are being forced out of their homes by entities that may not even hold the underlying loans.

>"This is the miracle of not having securities mapped to the underlying loans," said Josh Rosner, a specialist in mortgage securities at Graham-Fisher, an independent research firm in New York. "There is no industry repository for mortgage loans. I have heard of instances where the same loan is in two or three pools."

>Lawyers who represent troubled borrowers complain that trustees overseeing home loan pools often do not produce proof, usually in the form of a mortgage note, that their investors own a foreclosed property. And a recent study of 1,733 foreclosures by Katherine M. Porter, an associate professor of law at the University of Iowa, found that 40 percent of the creditors foreclosing on borrowers did not show proof of ownership. Such proof gives a creditor standing to foreclose against a borrower and is required by law.

Blog posting:
http://calculatedrisk.blogspot.com/2007/11/deutsche-bank-fc-problems-and-revenge.html
The folks at CalculatedRisk have more technical details about this and other things related to the mortgage problem.

NY Times article:
http://www.nytimes.com/2007/11/15/business/15lend.htm?_r=1&oref=slogin

People got too fast and slick, and no one really knows who owns what. A lot of people made a fortune on this "game" and it is going to hurt a lot to unwind the transactions. And since about 180 mortgage operations have been shuttered in the last year (see ml-implode.com for the bodycount), getting the documentation trail cleared up is going to become impossible in some situations. It might just become some sort of lottery for folks in trouble to hire a fast talking lawyer to dispute the ownership claims in court.

That inability to say "you own this" is why much of the credit market is collapsing. Too many "securities" have been sausagized into MBS/ABS/CDO "securities" to unravel, and this court decision shows that it looks to be turtles all the way down.

I despise the phrase "perfect storm" yet that appears to be an accurate description of the situation. There are crooks on every side of this problem contributing to the stink.