Credit Crunch "Bad Science"?

[Badly Shaved Monkey]

I have been trying to make some sense of the financial crisis we all seem to be caught up in, but I have been struck by what seems to be a contrast between the headlines telling us we have struck an iceberg and are sinking and what seem to be the data underpinning those headlines.

Typical headlines and reports concentrate on the "millions" of Americans defaulting on their mortgages and the huge rises in foreclosures.

But there are always "millions" of Americans defaulting on their mortgages, America is a big place and a minority of mortgages defaults is a permanent feature of economic life.

http://www.mbaa.org/NewsandMedia/PressCenter/64769.htm

It seems to me there has been a seriously misrepresentative use of relative changes to small absolute risks comparable to the misuse of "relative risk" data in medical scares that Ben Goldacre highlights in his book.

To draw some numbers from that MBAA page. Foreclosures have risen from about 1.45% to about 2.75%. That is a doubling, but it is an absolute rise of only 1.35%. Furthermore, that rise is almost by definition likely to be biased towards the lower end of the property-value scale, so the increased proportion of mortgage lending that is at risk is <1.35%.

Or, from another source:

"The proportion of homeowners delinquent on their mortgages but not yet in foreclosure reached 5.82 percent during the quarter, the highest level since 1985. That was up from 4.95 percent during the fourth quarter of 2006."


In the subprime area, there is obviously a specific problem (MBAA again),

"The delinquency rate decreased 12 basis points for subprime loans to 18.67 percent"

But I have seen estimates that subprime lending constitutes about 5% of the total, so even at a level of nearly 20% delinquencies, that is still only 1% of total lending, which aligns with the "<1.35%" I inferred above.

To add a little UK perspective on a related theme, we are given reports of the various House Price Indices and most often the news reports those produced by the Halifax and Nationwide Building Societies. These show double-digit price drops over 1yr. But, the less well-reported index produced by the Land Registry, that is based on actual price paid shows a much smaller rate of decline. Currently 4.6%. What is the difference? The lenders' indices are based on valuations made at the time that the loan is agreed. Clearly there are many factors at play there that make this different from price actually paid. The media seem to choose the scarier but less reliable indices.

Obviously there is a problem, but is the real problem more one of perception that the underlying economic situation: the headline bank-crashes reflect that minority of the market that geared itself tightly to the worst performing loans. Are we not now in a state where the fears of crisis are making that crisis a self-fulfilling prophecy more than the actual size of the necessary write-down in equity values?

In summary, if we could just accept that we're all 1-2% poorer than we were a year ago, would the current panic evaporate?

 

[Badly Shaved Monkey]

In summary, if we could just accept that we're all 1-2% poorer than we were a year ago, would the current panic evaporate?

...while allowing us the opportunity to laugh at a class of particularly smug bankers who have been caught in the blast when the manure hit the air-conditioning.

 

[roger]

In summary, if we could just accept that we're all 1-2% poorer than we were a year ago, would the current panic evaporate?

Well, no.

What we are going through right now is huge. Very sober people are saying that this is the biggest thing since either WWII or the Depression.

Big banks on Wall Street are toppling. BFD*, they got themselves into that mess, you probably retort, and as far as that goes I agree with you. But the problem is that our economy is based on credit. I'm not talking about your credit card. Most businesses have lines of credit to get them through week by week. In any normal business situation, this is fine. Rather than having tons of cash just sitting around doing nothing, the cash is invested, either in the business, or less liquid investments like bonds, CDs, equities, etc. Then, since cash flow is uneven (not many people came in the store this week), sometimes you don't have enough to do things like make payroll. Your employees aren't willing to take 1/2 a paycheck this week because business is slow. So you have a revolving line of credit, make payroll, then next month when business picks up you pay off the debt with the excess.

Another exampe: businesses like auto sales have millions of dollars of inventory on their property. It's not reasonable for them to have all the cash necessary to keep the lot full. So, the bank buys the cars for them, and as the cars move off the lot the business pays off part of the loan. This is why they try to move cars quickly, and why they are less likely to bargain with you with a car that has been on the lot for awhile- they owe more interest on it, and need to make back the money.

Now, the trouble is, the banks not only loan money to people and businesses, but each other. We are staring into the maw of the great depression. Would you, personally, loan me $1000 at 10% interest if you knew I was teetering on bankrupcy? (assume you knew me well enough that you would do so in normal circumstances - it's a nice rate of return). No! You'd be mad to take that risk. So, banks are not loaning to each other, and they aren't loaning to businesses. However, right now with a recession staring at us, businesses really need these loans. If you read the financial press, you'll see all kinds of companies, even companies with a very large cash balance and no debt, announcing that they have drawn down $700M, $2B, etc., on a line of credit they just established. Even though they don't need the cash now, they may need it in a year or two if we go into a deep recession. But that is only possible for companies with stellar credit ratings with relationships with one of the banks that hasn't blown up yet. The rest can't get loans, especially if they really, really need it now! So pop, pop, pop, banks blow up. Pop, pop, pop, individual businesses blow up, can't make payroll, and lay off people. pop, pop, pop, local businesses business dry up, and even though they don't need a loan, they aren't making money anymore because people aren't spending,and they lay off employees. Blam, great depression.

It has nothing to do with the fact that some relatively piddling amount of money was lost in mortages (well, that is the original cause, sure - the few flakes that made the snowball at the top of the hill), but with the fact that banks aren't lending. This will not have so much a ripple effect as a tidal wave effect. Sorry for the mixed metaphor.



* bountiful fugelhorns and drums, of course

 

[a_unique_person]

...while allowing us the opportunity to laugh at a class of particularly smug bankers who have been caught in the blast when the manure hit the air-conditioning.

They are still laughing at us. Whatever happens, (unless they were stupid enough to believe their own hyperbole), they still have the billions in salaries, bonuses and options they had before the crises, and there is no requirement whatsoever that they have to contribute to the collective bailout one cent more than the anyone else.

 

[Gate2501]

The only "bad science" that I can make out here, is the "science" behind taking Crackhead Joes subprime mortgage, and turning it into a AAA rated *ultra safe* security, totally based on a PREDICTION that the housing market had no ceiling!

Heads should roll. I support a summary execution of anyone who ever thought this was a good idea.

 

[69dodge]

roger, are you really disagreeing with Badly Shaved Monkey?

He didn't say that the problem is currently small. He suggested that perhaps it would become small if everyone decided to agree that it was small.

I wouldn't lend you money if you were about to go bankrupt, but, if the only reason for your (and everyone else's) impending bankrupcy is that no one was lending anyone money, I would agree to lend if everyone else agreed to too, because then you wouldn't go bankrupt, so I'd get my money back and save the economy in the process.

Well, it's easy to say I would agree, anyway. Maybe in reality I'd get scared, just like everyone is getting scared now. If credit is so important to the whole economy, why are the decisions about whether, and to whom, to extend it left up to people (bankers) who are concerned only with making a profit for themselves and not with the wider effects of those decisions? Everyone narrowly looks out for themself, and the result, sometimes, is that everyone ends up worse off.

 

[Nogbad]

The credit crunch is not so much based on foreclosures already in process but provisions banks have to make in their accounts for potential bad debts yet to come. That is, loans made to people with questionable ability to pay where the collateral (the house) is now worth less than the original loan. In such a circumstance if the borrower gets into trouble the cheapest option is to post the keys of the property through the bank letterbox and walk away.

Some banks exposed themselves to substantial bundles of these riskier debts and when they re-did the sums following the sharp downturn in house prices they realised they were borked. They could not produce accounts that showed they had the liquidity to cover potential bad debts. This in turn caused shareholder flight and the resultant blood bath recently seen in the financial markets.

The simple idea is that the various Governments around the world will underpin the banks with taxpayers' money. This covers the bad debts and should the borrowers default the taxpayers own the equity in the house - which in due course may once again be worth more than the debt covered and the taxpayer will not lose out. This underpinning returns liquidity to the banks' annual accounts and restores confidence in the market in their ability to do business profitably (assuming they don't go and do the same thing again of course).

While this doesn't make us "all socialists now" there is a refreshing slap of pragmatism about it all as political dogma bites the dust - it is a salutary lesson for the bankers too. The big problem is if the housing market continues to decline if say unemployment rises and recession bites. Then it all gets a bit trickier as ever decreasing circles come into play.

At least that is my view

 

[roger]

roger, are you really disagreeing with Badly Shaved Monkey?

He didn't say that the problem is currently small. He suggested that perhaps it would become small if everyone decided to agree that it was small.

Oky, I hear what you are saying. However, the other part of it is everyone is deleveraging, because they have to. Funds, banks, etc., are unwinding positions because they need cash to meet calls, etc. When you are highly leveraged, and you face 20% losses, that is catastrophic. If AIG had fallen, we would have been *******. Period. This is really, really scary. Big institutions, which we need, are teetering, and others are falling. This will be written about and talked about for the next 100 years. It's just not a matter of deciding it's not a big deal. It is a big deal. A 5% loss leveraged at 20x is death, not a shoulder shrug.

With that said, I agree that a lot of what is going on is due to lack of confidence. But there is more than just panic going on. Real institutions, ones that we really need, are gone or going.

Anyway, I'm just a yahoo in an armchair. For what it is worth, I'm putting cash into the equities market,so I'm betting we'll get through this. But it is scary.

 

[Francesca R]

I am not sure that issues of trust and confidence belong to natural science. Social science, yes.

 

[hamelekim]

I am not sure that issues of trust and confidence belong to natural science. Social science, yes.

Hence why Economics isn't a natural science. The market is based on trust and confidence. As long as those two things remain sound the math works.

As for the reality of the problem. There is a real problem, ask any economist or investor. There is no argument as to whether or not there is a problem, it's the solution that is disputed.

Look at the economic data, the increase in joblessness, the increase in goods and services. The problem is real, not imagined.

Paul Craig Roberts argues that the US should pay off the bad mortgages because they are the root of the problem. You pay those off and the various economic instruments that are currently worthless become worth something.

http://www.counterpunch.org/roberts10032008.html

The bailout is focused on the wrong end of the problem. The bailout should be focused on the origin of the problem, the defaulting homeowners. The bailout should indemnify defaulting homeowners and pay off the delinquent mortgages. As Koppell and Goetzmann point out, the financial instruments are troubled because of mortgage defaults. Stopping the problem at its origin would restore the value of the mortgage-based derivatives and put an end to the crisis.

This approach has the further advantage of stopping the slide in housing prices and ending the erosion of local tax bases that result from foreclosures and houses being dumped on the market. What about the moral hazard of bailing out homeowners who over-leveraged themselves? Ask yourself: How does it differ from the moral hazard of bailing out the financial institutions that securitized questionable loans, insured them, and sold them as investment grade securities? Congress should focus the bailout on refinancing the troubled mortgages as the Home Owners’ Loan Corp. did in the 1930s, not on the troubled institutions holding the troubled instruments linked to the mortgages. Congress needs to back off, hold hearings, and talk with Koppell and Goetzmann.Congress must know the facts prior to taking action. The last thing Congress needs to do is to be panicked again into agreeing to a disastrous course.

I tend to agree with him. This current bailout will do nothing to stop the continued collapse of the US and world economy.

 

[hamelekim]

You want more evidence that things are bad?

http://globaleconomicanalysis.blogspot.com/

William P. Lauder was already adjusting his corporate budget for a tough holiday season. Then the financial crisis hit. Amid the turmoil, the Estée Lauder Cos. (EL) chief executive stopped at a Denver mall and found it practically empty. Now he's preparing for the worst. "We always do scenario planning, but not to the degree that we are doing now," says Lauder. He's asking each brand manager at the New York cosmetics giant three questions: "What must you have? What would you like to keep going? And what can you give up?"

Faced with squeezed credit and unpredictable sales, U.S. companies are bracing for budget cuts that could be far-reaching, painful, and in some cases unprecedented. Even before September's turmoil, Moody's Economy.com predicted that corporate operating expenses—a proxy for budgets—would rise, on average, no more than 7% annually through 2012 across 59 industries, down from several consecutive quarters of double-digit gains.

 

[Jaggy Bunnet]

The credit crunch is not so much based on foreclosures already in process but provisions banks have to make in their accounts for potential bad debts yet to come. That is, loans made to people with questionable ability to pay where the collateral (the house) is now worth less than the original loan. In such a circumstance if the borrower gets into trouble the cheapest option is to post the keys of the property through the bank letterbox and walk away.

In fact this is almost always the most expensive option, not the cheapest one. Simply giving the bank the keys does not free the borrower from his obligations under the loan - he still owes exactly as much money as he did before, but now he has nowhere to live and the bank is going to flog the property as quickly as possible (and therefore not get the best price for it). If that doesn't clear the debt, then the borrower can and will be pursued for the balance.

 

[Whiplash]

I saw it reported on a couple of stations that the reason many lawmakers changed their votes was because they were hearing from constituents who called to say that they were not able to get loans for vehicles and homes. I've also seen it reported that many banks are not loaning to each other at all right now. If this is true, then clearly this situation is real and not being overstated.

 

[not_so_new]

I saw it reported on a couple of stations that the reason many lawmakers changed their votes was because they were hearing from constituents who called to say that they were not able to get loans for vehicles and homes. I've also seen it reported that many banks are not loaning to each other at all right now. If this is true, then clearly this situation is real and not being overstated.

I am not en economist but in the limited knowledge I have I think you are right, this is REAL and NOT being overstated.

Regardless of our opinion of Buffet pro or con, I think this interview is very telling on how important he thinks this is and his words carry some weight.

http://www.charlierose.com/shows/2008/10/01/1/an-exclusive-conversation-with-warren-buffett

 

[Nogbad]

In fact this is almost always the most expensive option, not the cheapest one. Simply giving the bank the keys does not free the borrower from his obligations under the loan - he still owes exactly as much money as he did before, but now he has nowhere to live and the bank is going to flog the property as quickly as possible (and therefore not get the best price for it). If that doesn't clear the debt, then the borrower can and will be pursued for the balance.

Sorry - forgot to add the "by the light of the moon" to the letterbox bit While it is true that the difference between the debt and the asset value is still owed - getting at that amount is easier said than done. Hence why it is toxic debt. Even Banks have difficulty with the blood from stone thing.

 

[drkitten]

In fact this is almost always the most expensive option, not the cheapest one. Simply giving the bank the keys does not free the borrower from his obligations under the loan - he still owes exactly as much money as he did before, but now he has nowhere to live and the bank is going to flog the property as quickly as possible (and therefore not get the best price for it). If that doesn't clear the debt, then the borrower can and will be pursued for the balance.

Not if the debt isn't worth pursuing the borrower for. The expression "you can't get blood from a turnip" applies here, and the banks are well aware of it. Someone who has sufficiently little in terms of assets and income that they think posting the keys back to the bank is probably not a good person to send threatening letters to. What are you going to do, repossess the apartment he now rents?

In many cases -- not all, but a large enough number to be truly scary to the banks -- the best thing to do is to eat the loss instead of throwing good money in "pursuit" of bad.

 

[Nogbad]

I should add that if one can weather the storm it is better to hang on to your property - in the long term it will recover in value. However, as Keynes said "in the longer term we are all dead".

 

[dudalb]

I just have to echo that applying concepts that work with the "Hard Sciences" to Social Sciences is asking for trouble.
Some otherwise very intelligent people have made fools of themsleves with this.

 

[Jaggy Bunnet]

Not if the debt isn't worth pursuing the borrower for. The expression "you can't get blood from a turnip" applies here, and the banks are well aware of it. Someone who has sufficiently little in terms of assets and income that they think posting the keys back to the bank is probably not a good person to send threatening letters to. What are you going to do, repossess the apartment he now rents?

In many cases -- not all, but a large enough number to be truly scary to the banks -- the best thing to do is to eat the loss instead of throwing good money in "pursuit" of bad.

You might not have assets today, but if you ever want to have assets again, then walking away and hoping the lender will forget about it is a very bad idea. They can, and do, pursue debts years after the property was repossessed.

"Nacab says a couple in Essex handed in the keys following a marriage breakdown in 1990. They were told that this would be the end of the matter. Both left forwarding addresses with the loan company but heard nothing before receiving a £55,990 shortfall debt demand in May 1999."

http://www.efbf.org/jobs/Press-Mounting-debts-haunting-the-repossessed-13890.htm

It happened to the people who were repossessed last time there was a downturn in the housing market. It will undoubtedly happen to people again this time. So, no they aren't going to repossess the apartment you rent after you hand the keys back, they are going to wait until you think you have got back on your feet and knock you right back down again.

 

[wuschel]

I just have to echo that applying concepts that work with the "Hard Sciences" to Social Sciences is asking for trouble.
Some otherwise very intelligent people have made fools of themsleves with this.

You certainly do not refer to the requirement put on any scientific theory that it makes testable predictions - about the future, not the past, mind?

If one drops that requirement, how is whatever remains different from following advise obtained by reading goat entrails?