After posting Felix Salmon's relatively optimistic take on the subprime mortgage situation, I received an email with a different view:
Optimists and Pessimists on Subprimes and the Markets Generally, naked capitalism: As readers may recall, Felix Salmon posted a very critical take, "Is there a looming crisis in the mortgage market?" on Gretchen Morgenson's New York Times story, "Crisis Looms in Mortgages." We parsed the two stories, drawing on other sources, in our "Reactions to New York Times Mortgage Market Story."
Since then, the markets took a dive, although they seem to have regrouped, and Salmon weighted in with another post, "Whither mortgages and housing?" It's much more nuanced that his first post, and allows for the possibility that the economy could get worse, but argues that subprime train wreck just isn't a big enough deal to have the impact that the markets are ascribing to it.
Ah, for the want of a nail, the shoe was lost, for the want of a shoe a horse was lost, for the want of a horse, a rider was lost.....
That may sound lame (no pun intended), but it takes surprisingly little to trigger a sharp correction when there is substantial overvaluation in the marketplace. In this case, the overvaluation, as we have discussed, is in the the credit markets. Very risky assets are trading at unprecedentedly ... small ... risk premiums... What happened in subprimes is just a painful reminder of what can happen when investors are too hungry for high yields.
There may not be another high-risk niche as large and visible as subprimes, but overeager money went into all kinds of speculative nooks and crannies, and investors are nervously waiting for the other shoe, or more likely, a lot of other shoes, to drop.
It also can take less than one might think to lead to a market rout. ... One of my friends who is very close to the prime broker community said that if there had been another leg down that same week [of February 27], a lot of hedge funds would have bailed out, out of both fear and necessity (margin calls). There would have been a massive rush to the exits. Another 1987? Almost certainly not. But an 8-10% loss in a week in the major markets around the world would have focused the mind.
And my sense, at least for now, that the psychology is very worried. That's why we had a 2% decline in New York and a 5% down opening in Tokyo (the Nikkei closed down only 2.9%) on fairly trivial bad news.
Similarly, economists are now worrying about worsening fundamentals. Friday's Wall Street Journal reports, in "Subprime Mortgage Woes Are Likely to Spread," that
Most economic forecasters in a new WSJ.com survey believe recent turmoil in the subprime mortgage market is likely to spread to the broader mortgage market and they expect a widely followed index of home prices to fall this year. But they still think the U.S. will avoid a recession and even a significant rise in unemployment... But, ... there is disagreement among the economists about the risks that the subprime market poses to the overall U.S. economy. ...
Back to Salmon, for his thinking typifies the optimistic case, and his argument is well reasoned. But there are enough of the particulars that I disagree with to make me take issue with his conclusion.
Narrowly, he is right. Subprimes aren't big enough to cause an investment rout. But they are a symptom of a lot wrong in the markets, and in the real economy.
I don't deny for a minute that the number of defaults on subprime mortgages, especially subprime mortgages of the 2006 vintage, is eye-poppingly high, and rising. What's more, given the fact that originators have tightened up their underwriting standards substantially (and correctly), many mortgage holders are going to find it hard to refinance their adjustable-rate mortgages when they reset. This could drive default rates even higher, if the rates on those mortgages go up a lot. Home prices are still substantially above their 2004 levels, however, so the real problem is largely confined to mortgages originated in 2005 and 2006.
Now, it's easy to paint a picture whereby defaults on recent-vintage mortgages cause a more generalized tightening in credit markets along with a plunge in housing prices as supply goes up and demand goes down. I do accept that, in theory, this could happen. But before I believe the prognostications of those who say it will happen, I want to see some indication that their model of supply and demand and housing prices actually reflects reality. Specifically, I want to see whether it explains the rise in housing prices over the past few years.
Let's look at the Economist. It had a great survey in June 2005 on housing bubbles, "In Come the Waves." It found the US housing market to be overvalued by 20% based on comparisons to rentals and incomes. And it noted that almost without exception, when a housing market corrects, values do not go down to fair value. They go considerably below fair value. And despite Salmon's doubts, housing recessions affect spending when consumers have been monetizing the gains to fund spending via equity loans:
Another worrying lesson from abroad for America is that even a mere levelling-off of house prices can trigger a sharp slowdown in consumer spending. Take the Netherlands. In the late 1990s, the booming Dutch economy was heralded as a model of success. At the time, both house prices and household credit were rising at double-digit rates. The rate of Dutch house-price inflation then slowed from 20% in 2000 to nearly zero by 2003. This appeared to be the perfect soft landing: prices did not drop. Yet consumer spending declined in 2003, pushing the economy into recession, from which it has still not recovered. When house prices had been rising, borrowing against capital gains on homes to finance other spending had surged. Although house prices did not fall, this housing-equity withdrawal plunged after 2001, removing a powerful stimulus to spending.
And the faith that even if housing is weak now, it will of course resume its inexorable rise? Yale economist Robert Shiller ... has determined that the real price appreciation in housing in the US from 1890 (no typo, we mean the end of the 19th century) and 2004 was 0.4%.
The current Economist, in "Shakedown," provides stronger evidence of housing overvaluation and bank laxity:
So what does this chart say? Americans in aggregate (and remember it takes a lot to move aggregate numbers) are spending more of their income on housing than in a generation and a half, perhaps longer, perhaps ever. And the banks have facilitated this development. It looks toppy to me.
Salmon has a couple of observations that don't stand him in good stead. The "New York is booming, housing wise, New York has few subprimes, ergo subprimes don't have anything to do with housing prices generally" doesn't wash. New York has become close to a one industry town driven by skyrocketing Wall Street comp. You can't make any generalizations to the rest of the country based on New York. As for the "very very sophisticated" holders of MBS and CDOs who can presumably take losses, the Financial Times quoted dealers who said that they were being bought by very unsophisticated players. An illustrative comment regarding CDOs:
"I don't think there has ever been a time in history when such a large proportion of the riskiest credit assets have been owned by such financially weak institutions....with very limited capacity to withstand adverse credit events and market downturns."
For a more adamant bearish view, see Nouriel Roubini's RGE Monitor for "The Ten Faulty Consensus Views about Sub-prime and Soft-Landing…and the Ten Ugly Truths about the Coming Economic and Financial Hard Landing." He forecasts a "growth recession" of 0-1%, or perhaps even a real recession. It's grim reading but worth considering.