Global finance

Where’s the next Lehman?

Five years after the maelstrom of September 2008, global finance is safer. But still not safe enough.

Sep 7th 2013

THE bankruptcy of Lehman Brothers, an American investment bank, in 2008 turned a nasty credit crunch into the worst financial crisis in 80 years. Massive bail-outs from governments and central banks staved off a second Depression, but failed to prevent a deep recession from which many rich economies have yet fully to recover. Five years after that calamity, two big questions need to be answered. Is global finance safer? And are more crises on the horizon?

The quick answers are yes, and yes. Global finance looks less vulnerable because reforms to the financial industry have made it more resilient, and because America, the country at the heart of the Lehman mess, has got rid of much of the excess debt and righted many of the imbalances in its economy. Today’s danger zones are elsewhere. They are unlikely to spawn a collapse on the scale of 2008. But they could produce enough turmoil to hit growth hard.

The three harbingers of the apocalypse

The disaster of September 2008 had many causes, as the first of our series of “schools briefs” (see article). But, put crudely, Lehman’s demise spawned catastrophe because it combined three separate vulnerabilities.

The underlying one was a surge in debt, particularly in the financial sector, brought on by a housing bubble. The ensuing bust was made more dangerous because of the second weakness: the complex interconnections of securitised finance meant that no one understood what assets were worth or who owed what. Lehman’s failure added a third devastating dimension: confusion about whether governments could, or would, step in as finance failed. A rule of thumb for spotting future disaster is how far those weaknesses—a debt surge, ill-understood interconnections and uncertainty about a safety net—are repeated.

The overhaul of financial regulation since 2008 has made most progress on the first two. Under the new Basel capital standards banks are being compelled to hold more, and better, capital relative to their assets; the biggestsystemicbanks even more than others.

Another strand of reforms, such as pushing derivatives trading onto clearing-houses, has tried to improve transparency. Least progress has been made on what to do when big banks fail—though new efforts to write global rules that would force banks to issue bonds that can bebailed in” in the event of failure is a promising step.

American finance has become safer. The country’s big banks have raised more capital and written off more dud assets than most others. At around 13%, their risk-weighted capital ratio is far above the new global norms and some 60% higher than before the crisis. American property prices have adjusted and households have cut their debts. Government debt has risen, but most of that rise is the sensible mirror-image of efforts by households to reduce theirs. Now that the economy is recovering, the budget deficit is tumbling. You can find bubbliness in bits of American finance, including the corporate-bond market, and some nasty off-balance-sheet liabilities like student loans and public-sector pensions, but America does not look like a source of imminent trouble.

Britain and Japan have changed less. Abenomics has improved Japan’s prospects, but government debt is still close to 250% of GDP. In Britain the combination of budget cuts and weak private investment has produced a recovery that is built on the same ingredients—particularly rising house prices—that caused the last bust. Britain is not about to fell the world economy, but growth that was based more on investment, both public and private, would be an awful lot safer.

What about emerging economies, many of which have seen a big run-up in debt? China is often dubbed a Lehman-in-the-making. Since 2008 credit growth in the Middle Kingdom, now the world’s second-largest economy, has exploded, and by some estimates is over 200% of GDP. China’s financial system has few international connections.

But, as in America in 2008, there is uncertainty about the true size of its debts and how much of them will be repaid. The danger China poses depends on the third ingredient of the Lehman conflagration: how the government behaves when trouble strikes. The country is a big net saver, the banking system is still largely deposit-funded and the government has the fiscal capacity to underwrite troubled loans. Provided it does so, the odds of a sudden collapse with global ramifications are low.

From Brazil to Thailand, many of the other emerging economies that are now wobbling have also seen credit booms. The difference with China is their vulnerability to global financial flows. Today’s drought in foreign capital is pushing down currencies like India’s rupee and making current-account deficits harder to finance. In the 1990s that dynamic caused crises. But this time round most countries’ defences are more powerful. Exchange rates float, far more debt is denominated in domestic currency and reserves are fatter. Some places may be overwhelmed: our index of vulnerability has Turkey flashing reddest. Most are likely to suffer slower growth.

The shadow over Europe

If there is one part of the world that could still bring about another global meltdown, it is the euro area. Though less Lehman-like than a year ago, it remains a worry. Its debt problems are growing, not shrinking: European banks have thinner equity buffers than their American counterparts, and have written down far fewer debts. In the troubled economies on Europe’s periphery recession has made it hard to reduce debt burdens of all sorts. Too much austerity has proved counterproductive. A destabilising political backlash remains a danger, given Europe’s sky-high jobless rates. Its sleepwalking leaders cannot agree on how to complete necessary reforms, such as a proper banking union, while the European Central Bank’s ability to live up to its brave pledge to “do whatever it takes” to save the euro remains untested.

There may be no new Lehman-sized catastrophes on the near horizon. But plenty of smaller crises-in-the-making dot the landscape—and a potentially big one continues to threaten Europe. Five years on, global finance is a long way from safe.

The origins of the financial crisis

Crash course

The effects of the financial crisis are still being felt, five years on. This article, the first of a series of five on the lessons of the upheaval, looks at its causes

Sep 7th 2013

THE collapse of Lehman Brothers, a sprawling global bank, in September 2008 almost brought down the world’s financial system. It took huge taxpayer-financed bail-outs to shore up the industry.

Even so, the ensuing credit crunch turned what was already a nasty downturn into the worst recession in 80 years. Massive monetary and fiscal stimulus prevented a buddy-can-you-spare-a-dime depression, but the recovery remains feeble compared with previous post-war upturns. GDP is still below its pre-crisis peak in many rich countries, especially in Europe, where the financial crisis has evolved into the euro crisis. The effects of the crash are still rippling through the world economy: witness the wobbles in financial markets as America’s Federal Reserve prepares to scale back its effort to pep up growth by buying bonds.

With half a decade’s hindsight, it is clear the crisis had multiple causes. The most obvious is the financiers themselves—especially the irrationally exuberant Anglo-Saxon sort, who claimed to have found a way to banish risk when in fact they had simply lost track of it. Central bankers and other regulators also bear blame, for it was they who tolerated this folly.

The macroeconomic backdrop was important, too. The “Great Moderation”—years of low inflation and stable growthfostered complacency and risk-taking. A “savings glut” in Asia pushed down global interest rates. Some research also implicates European banks, which borrowed greedily in American money markets before the crisis and used the funds to buy dodgy securities. All these factors came together to foster a surge of debt in what seemed to have become a less risky world.

Start with the folly of the financiers. The years before the crisis saw a flood of irresponsible mortgage lending in America. Loans were doled out to “subprimeborrowers with poor credit histories who struggled to repay them. These risky mortgages were passed on to financial engineers at the big banks, who turned them into supposedly low-risk securities by putting large numbers of them together in pools.

Pooling works when the risks of each loan are uncorrelated. The big banks argued that the property markets in different American cities would rise and fall independently of one another. But this proved wrong. Starting in 2006, America suffered a nationwide house-price slump.

The pooled mortgages were used to back securities known as collateralised debt obligations (CDOs), which were sliced into tranches by degree of exposure to default. Investors bought the safer tranches because they trusted the triple-A credit ratings assigned by agencies such as Moody’s and Standard & Poor’s.
This was another mistake. The agencies were paid by, and so beholden to, the banks that created the CDOs. They were far too generous in their assessments of them.

Investors sought out these securitised products because they appeared to be relatively safe while providing higher returns in a world of low interest rates. Economists still disagree over whether these low rates were the result of central bankers’ mistakes or broader shifts in the world economy. Some accuse the Fed of keeping short-term rates too low, pulling longer-term mortgage rates down with them. The Fed’s defenders shift the blame to the savings glut—the surfeit of saving over investment in emerging economies, especially China. That capital flooded into safe American-government bonds, driving down interest rates.

Low interest rates created an incentive for banks, hedge funds and other investors to hunt for riskier assets that offered higher returns. They also made it profitable for such outfits to borrow and use the extra cash to amplify their investments, on the assumption that the returns would exceed the cost of borrowing. The low volatility of the Great Moderation increased the temptation to “leveragein this way. If short-term interest rates are low but unstable, investors will hesitate before leveraging their bets. But if rates appear stable, investors will take the risk of borrowing in the money markets to buy longer-dated, higher-yielding securities. That is indeed what happened.

From houses to money markets
When America’s housing market turned, a chain reaction exposed fragilities in the financial system. Pooling and other clever financial engineering did not provide investors with the promised protection. Mortgage-backed securities slumped in value, if they could be valued at all. Supposedly safe CDOs turned out to be worthless, despite the ratings agencies’ seal of approval. It became difficult to sell suspect assets at almost any price, or to use them as collateral for the short-term funding that so many banks relied on. Fire-sale prices, in turn, instantly dented banks’ capital thanks to “mark-to-marketaccounting rules, which required them to revalue their assets at current prices and thus acknowledge losses on paper that might never actually be incurred.

Trust, the ultimate glue of all financial systems, began to dissolve in 2007—a year before Lehman’s bankruptcy—as banks started questioning the viability of their counterparties. They and other sources of wholesale funding began to withhold short-term credit, causing those most reliant on it to founder. Northern Rock, a British mortgage lender, was an early casualty in the autumn of 2007.

Complex chains of debt between counterparties were vulnerable to just one link breaking. Financial instruments such as credit-default swaps (in which the seller agrees to compensate the buyer if a third party defaults on a loan) that were meant to spread risk turned out to concentrate it. AIG, an American insurance giant buckled within days of the Lehman bankruptcy under the weight of the expansive credit-risk protection it had sold. The whole system was revealed to have been built on flimsy foundations: banks had allowed their balance-sheets to bloat (see chart 1), but set aside too little capital to absorb losses. In effect they had bet on themselves with borrowed money, a gamble that had paid off in good times but proved catastrophic in bad.

Regulators asleep at the Wheel
Failures in finance were at the heart of the crash. But bankers were not the only people to blame. Central bankers and other regulators bear responsibility too, for mishandling the crisis, for failing to keep economic imbalances in check and for failing to exercise proper oversight of financial institutions.

The regulators’ most dramatic error was to let Lehman Brothers go bankrupt. This multiplied the panic in markets. Suddenly, nobody trusted anybody, so nobody would lend. Non-financial companies, unable to rely on being able to borrow to pay suppliers or workers, froze spending in order to hoard cash, causing a seizure in the real economy. Ironically, the decision to stand back and allow Lehman to go bankrupt resulted in more government intervention, not less. To stem the consequent panic, regulators had to rescue scores of other companies.

But the regulators made mistakes long before the Lehman bankruptcy, most notably by tolerating global current-account imbalances and the housing bubbles that they helped to inflate. Central bankers had long expressed concerns about America’s big deficit and the offsetting capital inflows from Asia’s excess savings. Ben Bernanke highlighted the savings glut in early 2005, a year before he took over as chairman of the Fed from Alan Greenspan. But the focus on net capital flows from Asia left a blind spot for the much bigger gross capital flows from European banks. They bought lots of dodgy American securities, financing their purchases in large part by borrowing from American money-market funds.

In other words, although Europeans claimed to be innocent victims of Anglo-Saxon excess, their banks were actually in the thick of things. The creation of the euro prompted an extraordinary expansion of the financial sector both within the euro area and in nearby banking hubs such as London and Switzerland. Recent research by Hyun Song Shin, an economist at Princeton University, has focused on the European role in fomenting the crisis. The glut that caused America’s loose credit conditions before the crisis, he argues, was in global banking rather than in world savings.

Moreover, Europe had its own internal imbalances that proved just as significant as those between America and China.

Southern European economies racked up huge current-account deficits in the first decade of the euro while countries in northern Europe ran offsetting surpluses. The imbalances were financed by credit flows from the euro-zone core to the overheated housing markets of countries like Spain and Ireland. The euro crisis has in this respect been a continuation of the financial crisis by other means, as markets have agonised over the weaknesses of European banks loaded with bad debts following property busts.

Central banks could have done more to address all this. The Fed made no attempt to stem the housing bubble. The European Central Bank did nothing to restrain the credit surge on the periphery, believing (wrongly) that current-account imbalances did not matter in a monetary union. The Bank of England, having lost control over banking supervision when it was made independent in 1997, took a mistakenly narrow view of its responsibility to maintain financial stability.

Central bankers insist that it would have been difficult to temper the housing and credit boom through higher interest rates. Perhaps so, but they had other regulatory tools at their disposal, such as lowering maximum loan-to-value ratios for mortgages, or demanding that banks should set aside more capital.

Lax capital ratios proved the biggest shortcoming. Since 1988 a committee of central bankers and supervisors meeting in Basel has negotiated international rules for the minimum amount of capital banks must hold relative to their assets. But these rules did not define capital strictly enough, which let banks smuggle in forms of debt that did not have the same loss-absorbing capacity as equity.

Under pressure from shareholders to increase returns, banks operated with minimal equity, leaving them vulnerable if things went wrong. And from the mid-1990s they were allowed more and more to use their own internal models to assess riskin effect setting their own capital requirements. Predictably, they judged their assets to be ever safer, allowing balance-sheets to balloon without a commensurate rise in capital (see chart 2).

The Basel committee also did not make any rules regarding the share of a bank’s assets that should be liquid. And it failed to set up a mechanism to allow a big international bank to go bust without causing the rest of the system to seize up.

All in it together
The regulatory reforms that have since been pushed through at Basel read as an extended mea culpa by central bankers for getting things so grievously wrong before the financial crisis. But regulators and bankers were not alone in making misjudgments. When economies are doing well there are powerful political pressures not to rock the boat. With inflation at bay central bankers could not appeal to their usual rationale for spoiling the party. The long period of economic and price stability over which they presided encouraged risk-taking. And as so often in the history of financial crashes, humble consumers also joined in the collective delusion that lasting prosperity could be built on ever-bigger piles of debt.

Here Are the Real Labor Force Dropouts

By Rick Newman

The Exchange – 1 hour 59 minutes ago

So who, exactly, is dropping out of the labor force? It’s well-known that male-dominated industries such as manufacturing and construction have endured painful and probably permanent shrinkage, which suggests a lot of middle-aged, blue-collar men are now sitting on the sidelines. Some analysts feel extended unemployment insurance has given a lot of laid-off workers a stronger incentive to collect a government check than look for a job. Then there are critics of the “47 percent” (now the 43 percent) of adult Americans who pay no income tax yet somehow eke out a living.

But the numbers tell a somewhat different story about who the labor force dropouts really are. Here are labor force participation rates for different age groups in 1990, 2000 and 2013:

Bureau of Labor Statistics data

The biggest drop-off has come among young workers. The recession and subsequent weak recovery have cut sharply into opportunities for entry-level workers, in virtually all industries. Some simply can’t find work. Others have chosen to go to college or graduate school instead of looking for a job.

The job woes of this “Millennialgeneration have garnered plenty of attention. More twenty-somethings live with their parents these days, which has torpedoed the rate of new-household formation and left homebuilders and automakers anxiously wondering who will buy their products in five or 10 years. The amount of student debt has mushroomed, as many students pay for college with readily available (and often federally backed) loans. Many grads are starting their careers deep in the hole, since they can’t find jobs that pay enough to cover their loan payments while still allowing them to live independently.

Those are legitimate problems, but it’s also possible that a better educated workforce will pay dividends in a few years' time. College enrollment rates grew at a moderate pace until 1999, then began to increase more sharply.

The recession lured even more people into higher ed, including a lot of older adults who attended community college to hone new skills. And sure enough, enrollment rates have begun to drift downward now that more young people sense an improving job market and feel they’re more likely to find work.

Potential benefits

That education bulge could give the economy a boost in the future, much as the G.I. Bill did in the 1950s and ‘60s. Consulting firm McKinsey, for instance, predicts that by 2020, the U.S. economy will face a shortage of about 1.5 million college-educated workers.

If so, demand (and pay) will rise for those who do have a degree, turning at least some of today’s workforce dropouts into tomorrow’s productive workers. Also, more students have been choosing math and science majors, which seem more likely to lead to profitable work and perhaps a more innovative economy.

It also stands to reason that some dropouts in other age brackets will return to the workforce when, or perhaps if, the job market improves enough to make it worth their while. Some dropouts are still working plenty hard as stay-at-home parents or caregivers to their own elderly parents, having made a pragmatic decision that it’s not worth the trouble to work in an iffy economy while paying someone else to help with their family obligations.

Also notable is that the participation rate for men over 55 has gone up considerably. That makes sense, since those close to retirement may have the greatest need to pad their savings.

Established workers are also in the best position to simply stay in their jobs instead of retiring, compared with younger workers who haven’t even found a job in the first place. If older workers gradually improve their finances and once again begin to retire earlier, that could open the door for younger workers to move into their jobs, which might improve hiring down the entire employment food chain.

The real question about labor force dropouts is whether there would still be an elevated number if the economy were as productive today as it was in the late 1990s or even the late 1980s. It might make sense to drop out when the rewards for your work are fairly low. But if workers leave even when the rewards of work go up, then something fundamental has changed. That could end up being the biggest threat to the nation’s future prosperity.

Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

Housing Market

The All-American "Short Squeeze" No One Else Sees

By Shah Gilani, Capital Wave Strategist, Money Morning

September 6, 2013

Everyone knows the U.S. housing "recovery" has been resurrected on slippery ground. But now that we're finally about to slip - big time - no one sees it coming...
Then again, how could they?

The numbers are incredibly misleading...

According to the Commerce Department, new residential home sales in July fell a whopping 13.4% from their June sales pace. And sales in April, May, and June were all revised significantly lower.

Yet according to the National Association of Realtors, existing home sales (completed transactions that include single-family homes, townhomes, condominiums, and co-ops) increased 6.5%... to a seasonally adjusted annual rate of 5.39 million in July, from a downwardly revised 5.06 million in June.

On the surface, the divergence is confusing. But not when you look below the surface, where the real money gets made.

As you'll see (before anyone else), the housing "recovery" is just one giant "short squeeze."

And you can make a flat-out killing the moment it ends...

Meet America's Biggest Home Buyers

The divergence in sales of new homes vs. existing homes can be explained as a function of three factors: investor interest, pricing, and potential appreciation.

In just the last two years, institutional investors, hedge funds, private equity firms, and real estate investment trusts have raised more than $18 billion and bought more than 100,000 single-family homes.

Blackstone Group L.P.'s Invitation Homes unit has spent over $5 billion buying more than 32,000 single-family homes. They are the largest owner of homes in the United States.

American Homes 4 Rent, which went public last month and is the second-largest single-family homeowner in the United States, has spent $3.4 billion buying up almost 20,000 single-family homes and said in their August earnings call that they're spending $100 million a month buying more homes.
These institutional buyers aren't buying new homes in bulk; they're buying existing homes in bulk... and one at a time.

New homes, built by giant national builders like Pulte, Lennar, and Toll Brothers, as well as new homes built by small regional and local builders, are priced according to their cost to build, with hoped-for profit margins added on. Generally, there isn't a lot of negotiating room on prices.

Additionally, new homes are financed by builders' banks who build cushions into their loans. And since loans are "new," they can remain outstanding a lot longer than old loans before banks have to classify them as "non-performing."

That gives builders of new homes greater pricing and staying power. In other words, builders aren't readily discounting their inventories to make them attractive to new home buyers.

On the existing homes' side of the street, there's a lot more room to negotiate...

A Crowd of Highly Motivated Sellers... Who Love Cash

Distressed property owners - banks holding foreclosures, beleaguered individual owners, and short-selling owners (those selling homes for less than their mortgaged loan values) - have all been eager to sell... especially for cash, which institutional buyers readily dangle in front of them.

While institutional investors often pay cash, they are in fact financing the cash they're laying out. With interest rates as low as they are, especially for corporate borrowers able to float their I.O.U.s in the bond market, amassing cash hoards against their stock-based equity collateral (via covenant-lite bond offerings) adds to their massive buying power.

New homes tend to appreciate based on "at-the-market" trends, while existing homes are often perceived as having inherently more room to appreciate. That's because many existing homes were previously valued significantly above current market prices. Homes in neighborhoods that once enjoyed solid appreciation rates but have been deeply discounted are desirable purchases on account of the "bounce-back in price" perception.

That's why existing home sales have held up better than new home sales.

Now let's look at house price appreciation trends, which have been robust to say the least.

Just keep in mind the impact the billions of dollars being applied to the market by institutions is having on pricing trends in the existing home market...

A Dangerous Double Dip Looms

The national median existing home price for all housing types was $213,500 in July, which is 13.7% above July 2012 and marks 17 consecutive months of year-over-year price increases, which last occurred from January 2005 to May 2006.

The median price rose at double-digit rates for the past eight months and is only 7.3% below the all-time record of $230,400, posted in July 2006. Two years ago, the median price was 25.7% below the peak.

New home prices haven't risen as quickly. In 2009, after falling 6.6% from faltering 2008 prices, the median new home price was $216,700. As of July 2013 the median new home price is $257,200, which is an 18% increase over the 2009 price level.

In spite of the recent divergence in the pace of sales and rates of change in sales trends between existing and new homes sales, prices on both streets have risen steadily.

Given the rapid appreciation rates of both new and existing home prices and the outsized impact institutional buying has had on existing home sales price appreciation, unless inventories of new and existing homes drop precipitously, it's not only unlikely that the recovery in housing will continue, but it's likely to peter out and result in a double-dip backward slide.

Why? Housing has risen too far too fast off its floor given trends in economic growth, employment, interest rates, lending standards, mortgage money availability, and consumer confidence.

We're already seeing a back-up in pending sale contracts, refinancings, and new money purchase loans on account of the tick up in rates. Which, on a historic basis, are still very low. If rates continue to climb on the long end of the yield curve, buyers will balk. If rates tick up on the short end of the yield curve, banks will balk at lending. In other words, if the Fed does not continue to engineer a steep yield curve, then purchase money will become tighter and tighter.

There can't be any meaningful recovery in housing beyond the bounce we've seen unless lenders loosen underwriting standards and make loans plentiful.

The back-office mechanics that previously facilitated the robust velocity of mortgage money availability, meaning the ability of lenders to package, securitize, and offload loans from their balance sheets, are still clogged up.

Risk-retention rules pertaining to how much lenders have to retain on their balance sheets against loans they make, in the form of the as-yet unfinished qualified residential mortgage (QRM or QM) rules, will be an impediment to robust lending.

U.S. regulations and Basel rules are still being written, rewritten, and challenged by banks who argue that more stringent reserve ratios, leverage ratios, and risk-asset definitions will be too restrictive and will result in credit tightening. So far, the net result is that banks aren't inclined to flush mortgage conduits with money if they don't know how those loans will be accounted for by regulators.
The bottom line, again:

You can't sustain a robust housing recovery without banks' willing participation.

Then there's the economy, unemployment, and home purchaser confidence.

None of those metrics are encouraging.

While second-quarter GDP growth was revised to 2.5% from 1.7%, the pace of growth remains well below the expected 3% rate economists had projected for 2013.

Unemployment is still stubbornly high and may remain above 7% as the new structural level of unemployment becomes harder and harder to bring down.

Technology and productivity gains have eviscerated middle-management jobs, and Obamacare threatens to reduce the ranks of the fully employed in the future as companies opt for more part-time workers to reduce their mandated contributions under the new healthcare regime rules.

This Is a Classic Short Squeeze

Last, but certainly not least, future homebuyers are witnessing the evaporation of their own potential equity build-up as rapidly rising prices are squeezing any cushion new buyers would have hoped to enjoy. As that appreciation gets ratcheted out of the market for new buyers, banks will increasingly demand more skin in the game on account of expected or hoped-for equity cushion build-up rapidly disappearing.

The rapid rise in home prices looks to me like a classic short squeeze.

Investors have bid up home prices off the floor so as to make rentals more expensive and force individual homebuyers to pay full price for whatever inventory is on the market.

Once the trade is fully priced and at new highs, on a relative time and appreciation basis, the buying power represented by the bottom-feeding institutional money will dry up, and only homebuyers in a solidly growing economy with greater employment opportunities and bankable confidence will be left to take prices higher and provide forward momentum for the recovery in housing.

As a trader, I say: "Good luck with that."

I'll be watching the trend rollover and will look to short the housing recovery in the not too distant future.

I'll let you know...