Hitting Stock Bottom
According to Charles Morris, "the stage is set for a true shock-and-awe surge of asset writedowns"—that is, investor losses—"through most of 2008."
His estimate: "The Trillion Dollar Meltdown," or 7 percent of the nation's GDP.
But Morris' book, based on "moderate assumptions," is not an outlandish prediction for the economy, but a sober prescription. In this compact volume, Morris clearly—and correctly—sides with observers of today's turmoil who think that any government attempt to save market participants who've made colossal miscalculations would come at the price of killing confidence in the markets in general. Any "salvation" would be a far worse long-term prospect than even the highest-profile bank failure.
Morris, a former banker and the author of the 1990 book "The Coming Global Boom," carefully lays out the bank and investor losses we can expect over the next year from all manner of debt defaults and other deals gone wrong.
What do these losses look like? First, as everyone knows by now, we've got subprime and other "high-risk" mortgage defaults, as banks slowly figure out that many of their borrowers can't repay loans. But what's been billed as the "subprime mortgage mess" in the media is just the beginning. Hundreds of billions more in losses are to come, Morris posits, on everything from the loans that private-equity firms took out to buy shaky companies to credit-card defaults as consumers find they just can't keep up.
Considering that banks have already given him a nearly 20 percent down-payment on his $1 trillion figure via their recent mortgage-related losses, Morris's guess isn't crazy. Indeed, numbers like $40 billion in commercial-mortgage default losses and $67 billion in credit-card losses sound low. He notes how losses feed on each other; that is, once a ratings agency downgrades a bond, for example, many institutional investors have to sell that bond since they're not allowed to hold junk bonds in their portfolios, thus creating lower prices and even more losses.
How did we get here? Morris takes a tour from Nixon-era dollar debasement and price and wage controls to the comparatively—although far-from-completely—free-market attitudes of policymakers of the '80s and '90s. Freer markets revitalized our economy beginning a quarter-century ago, but markets boom and bust, and, with help from rock-bottom interest rates, they created a dangerous credit bubble in recent years. Unfortunately, the aftermath of this burst bubble may send the pendulum back to Nixon-era solutions.
Morris delves into the lending frenzy of the past half-decade, when the world was happy to invest in our dollars despite the low interest rates. "When money is free, and lending is costless... the rational lender will keep on lending until there is no one else to lend to," he notes.
That's why anyone could get a mortgage until early last year—because banks knew the borrower could always refinance with more free money when he fell behind. Banks and investors loaned just as freely to wobbly corporations, speculative real-estate developers and opaque hedge funds.
Morris discusses a few preludes to the current mess, including a 1994 crash in some mortgage-backed debt that should have been a warning to banks' risk managers that such securities, even when conservatively structured, could be impossible to value when everything wasn't going swimmingly.
To explain how some of these deals work, Morris discusses a potential aspect of the bust that hasn't yet hit the front pages: credit default swaps, a type of insurance on a bond. Credit default swaps, just like mortgage-backed securities, aren't necessarily bad—but Morris argues that the credit bubble caused hedge funds and their partner institutions to use them to dangerous excess.
To wit: if I've got a $100 million portfolio of mortgage-backed bonds and want to insulate myself from the risk of those bonds without selling them, I could go to a hedge fund and pay it a couple of million to take that risk—that is, if the bonds go bust, the hedge fund pays me for some or all of my losses. As Morris notes, hedge funds and other institutions haven't taken this risk solely with their own money. Instead, they've borrowed heavily, often from the same banks that have already taken huge losses in their mortgage investments to magnify their returns.
Until now, some hedge funds have been good at taking the money to provide that insurance. "The hedge funds' appetite for the riskiest positions has made them a major source of liquidity in the... credit default swap markets," Morris writes, citing a Fitch Ratings study. But Morris thinks we're about to find out what everyone comes to collect at once.
hat would the trough of a credit driven recession look like to the average person who never heard credit-default swaps or even mortgage-backed securities until recently? To take one example: Americans took nearly three-quarters of a billion dollars out of their homes in 2005 based on the rising value of their homes, up from just $14 billion a decade previously, often "paying off [the] old loan and buying a new car with the difference." As home prices fall, people won't be able to suck cash out of their houses to spend; that's why we see consumer spending beginning to fall off. Lower consumer spending portends higher unemployment and more stock-market losses as corporate earnings drop off. Add it all up, and Americans may be in for a painful few years, more painful than we've seen in two generations.
But Morris sees a real "disaster," though, not in the overall credit bust itself, but in our possible reaction to it—that is, the possibility that government officials, prodded by powerful financial executives, will "downplay and conceal" the real losses to avoid the pain. Such a reaction, similar to the instinct of Japan's "tight network of... politicians and bankers" to conceal huge credit losses in their own bust, "is a path to turning a painful debacle into a decades-long tragedy," he warns.
This warning is well taken, particularly in light of the Bush administration's aggressive effort to take on responsibility for avoiding home foreclosures and the leading presidential candidates' proposed housing bailout packages.
Another ultimately futile and economically decimating way to save some Americans from foreclosure or higher mortgage payments would be for the Fed to keep interest rates at rock bottom, further harming the dollar, whose recent loss of value Morris does ably, and harrowingly, chronicle.
To that end, Chairman Bernanke's statement last week that he'll worry about recession now and inflation later was a bad sign; once inflation starts to grow at a fast clip, it feeds on itself, and it's painful to put it back in its box.
It's just as well that Morris didn't delve into some of the most excruciating details of the what-ifs of the next few years—"The Trillion Dollar Meltdown" is worrying enough.
"The Trillion Dollar Meltdown, Easy Money, High Rollers, and the Great Credit Crash" by Charles R. Morris (PublicAffairs)
This piece originally appeared in New York Post
This piece originally appeared in New York Post