Age of Wisdom, Age of Foolishness (Part 3)
Age of Wisdom, Age of Foolishness “Les Miserables”[i] observed how the culture and aspirations of economic mediocrity have pervaded and corrupted the cohorts of the American polity narrowly defined by their pecuniary interest in the status quo. The status quo is one of economic underachievement, which calls for the maintenance of the current policy stance of the Federal Reserve. Congress has abrogated its responsibility for creating an environment in which business can flourish, in order to receive “profit” from the Fed’s open market operations instead of tax revenues from industry and commerce. There is no incentive for companies to invest in economic growth, because there is no growth. What exists is an unhealthy stasis; in which capitalists seek rentier income from a shrinking asset pool, in the absence of the creation of new income generating assets. The shrinking asset pool means that capitalist investors must increasingly take on more exposure to existing (often distressed) risky assets, in the absence of new healthy growing assets. Pushing on this string is the Fed, which also finds itself running out of healthy assets to invest in. The whole investing universe in the United States is therefore consumed in the race to the bottom, in terms of credit quality.
There seems to be debate over whether this should be called a Bubble, because the booming economic conditions associated with previous bubbles is absent. What commentators have failed to grasp is that the preservation of these mediocre economic fundamentals is the vital interest of those chasing the mediocre assets. Survival of the fittest (minority) requires the survival of the un-fittest (majority). Preservation of this economic mediocrity is in the pecuniary interest of all those with “Risk-On” skin in the game. The Bubble is therefore in mediocrity; and the Stock Market, traditionally a signal of economic health, is now a barometer of this mediocrity. The rising equity markets are rationalised as signalling better economic times ahead, when actually they rise to discount the monetary responses to worse times ahead. The investment community, sitting on its capital gains, therefore proselytises the logic of the “Melt Up” in equity prices. The Fed dare not break this cycle of mediocrity, because in doing so it would create large losses for itself in both financial and credibility terms.
The cycle of mediocrity was reinforced last week by the confirmation hearings of Janet Yellen. Her testimony and Q&A sessions offered nothing in contrary to the status quo. The global capital markets heaved a great sigh of relief that she does not intend to rock the boat, by indulging in greater monetary largesse than is currently envisaged. She has therefore set herself up for the inevitable first test of her Chairmanship, when the markets suddenly perceive that they are discounting economic growth that does not exist. The Fed will then have to oblige the markets with more and also a possible permanent increase in liquidity. The markets will then be supported by the assertion that they are discounting the positive economic impacts of this new monetary largesse; after which those involved can get on with reinforcing the underlying economic mediocrity of the situation which justifies this continued largesse.
The latest Fed Balance Sheet data signaled the unfolding disconnect between monetary policy action and economic reality.
Fed Balance Sheet
Released On 11/14/2013 4:30:00 PM For wk11/13, 2013
Released On 11/14/2013 4:30:00 PM For wk11/4, 2013
The Fed’s Balance Sheet grew with a forty billion spike in the volume of Mortgage Backed Securities (MBS) purchased. This was preceded by growth in the Money Supply (M2) which actually was a contraction. Reserves are growing whilst credit creation is contracting. Looked at in another way, the Banks reduced exposure to the housing market and the consumer, whilst the Fed increased its exposure directly to the former and indirectly to the latter. The process of “Disintermediation”, observed in Terminal Velocity (28) “Disintermediated”[ii], through which the Fed gets itself deeper into trouble took another quantum step forward. Charles Plosser clearly does not enjoy this position; and once again he opined that the Fed should only be buying Treasuries.
The New York Fed’s Household Debt Survey did its best to try and claim that the deleverage cycle ended in September[iii].
It may be the case that serious delinquencies are leveling off; but it is also clear that new less severe distress (sub-120 days) is continuing to rise. Presumably today’s new distress will become tomorrow’s severe distress. It is therefore hard to take what the New York Fed is saying seriously, especially as this anecdotal evidence does not concern the period of time surrounding the Debt Ceiling debacle and the “Shutdown”.
The trouble that the Fed is getting deeper into was very evident last week. The unfolding events of the week were framed in a rich context opined by a repentant former “Q-Easer” named Andrew Huszar[iv]. Whilst working on the QE programme, as a Fed official, Mr Huszar began to experience feelings of guilt born out of the knowledge that the Fed was helping the banks and the owners of financial assets at the expense of the real economy. Fed liquidity poured into financial assets rather than the real economy. In fact, the continued pouring of Fed liquidity into financial assets required the continued suffering of the real economy. This situation has apparently become too much for the repentant Mr Huszar to remain silent about. Since the Fed is now the most at risk, from the collapse in asset prices that any exit from QE would bring, it has itself become the Too Big to Fail systemic risk that it is supposed to be protecting the whole financial system from. This ultimate systemic risk was explained in Age of Wisdom, Age of Foolishness “Les Miserables”[v] as a consequence of the drop in lending standards by the Banks because they no longer retained any lending risk on their book. What has been defined as “Disintermediation”[vi] and is evident in the most recent Fed Balance Sheet Data, continues to inflate the systemic risk level. “Les Miserables”[vii] observed the positioning of the rating agency Fitch in relation to this bubble. Further noises from the rating agency community served to reinforce the threat level. Former Moody’s executive, William Harrington blew the whistle on the rating agency community last week[viii]. In his whistle-blowing analysis, he observed that the AAA ratings assigned to Asset Backed Securities (ABS) are incorrect. Since the Credit Crunch, juries have not upheld the “Flip Contract” clause, by which holders of the first default notice on an underlying loan receive priority in liquidation proceedings. The legal foundation of the credit seniority which underpins the capital structure, on which credit ratings are assigned to Asset Backed Securities (ABS), has been eroded by legal precedent. The Fed is however expanding its scope of balance sheet activities to encompass all forms of ABS; which means it is walking into a legal minefield. What this means in practice is that the AAA MBS, which the Fed is accumulating, are therefore not legally AAA at all. It may the case as was found in Europe with the ECB that, in the event of liquidation proceedings, the Fed is able to assert its precedence. However, in this case we are dealing with private rather than sovereign debt securities, in which the Fed ranks equal in the blind eyes of American jurisprudence. There is a strong case to be made that the Fed actually ranks behind other private creditors; since its actions to date have created the precedent that it will bail out all other financial interests before its own. Combining the observations of Mr Huszar and Mr Harrison, one can see that the Fed has built in the redundancy which makes it the prime source of systemic risk. As we observed in “Les Miserables”[ix] the Banks are the facilitators of this process. This gives them control over the level of systemic risk that the Fed can ultimately assume; for which they have just raised their enabling fee in terms of the Interest Paid (by the Fed) on Reserves.
Compounding the growing risk was the latest information which showed that the “Acronyms”, known as HAMP and HAFA, are no longer working their magic to reduce mortgage default rates[x]. HAMP, the “Home Affordable Mortgage Modification Programme”, acts by reducing the value of principal mortgage payments; as a consequence these mortgages are not GSE eligible for securitization and acquisition by the Fed. HAMP is therefore not a programme that can be facilitated with liquidity from the Fed; so that it is a hostage to the intentions and capabilities of private sector lenders. During the recovery in house prices, private lenders were happy to comply with HAMP because it was raising the market value of their underlying housing assets. Lenders were happy to take the hit on the reduced loan principal value, because the house was rising by more in value than the HAMP haircut. It would seem that this is no longer the case, now that the rise in house prices has been stalled by the rise in mortgage interest rates. The HAMP programme hit a brick wall in September. The “Acronym” known as HAFA, “Home Affordable Foreclosure Alternative”, involves the distressed borrowers short-selling their deeds in lieu of default. Similarly, when house prices were recovering private investors were happy to take the other side of the short-sale. Now that house prices have stalled, there is no appetite to be on the other side of the deed short-sales. The loss of upward momentum in house prices correlates threateningly with loss in momentum of HAMP and HAFA. It was interesting to see the umbrella organization for HAMP and HAFA, the Making Homes Affordable programme (MHA), trying its best to do some cheerleading just as the evidence is starting to show that these initiatives are not working[xi]. The MHA opined the $ 22 Billion in savings for the distressed borrowers, from using HAMP, in the hope that new refinancers could be found who were previously not availing themselves of this opportunity. The MHA didn’t make much emphasis on the $22 Billion lost to taxpayers in this wealth transfer. Nor did it explain that these taxpayers had actually lost much more, in terms of opportunity cost, because interest rates have risen over the course of Q2 and Q3. What now seems to be the case is, at subsidised rates of interest, that the refinancing rates are still too high even when principal payments have been substantially cut by HAMP. In the absence of lower interest rates, the only thing to do to save the programme is to cut the principal payment even more. The MHA provided a neat little chart, which showed that delinquency improves substantially as the mortgage principal is reduced (below).
If house prices are not rising however, it is unlikely that private lenders will accept further cuts in principal because there is no quid pro quo. The neat chart (above) is therefore academic and impractical.
Some additional distressing signals were also found emanating from the other “Acronym” known as HARP. HARP mortgages are GSE eligible, since they involve a reduction in interest rate paid rather than principal. With the shutdown of HAMP (and HAFA) HARP is the only “Acronym”, currently in action, which can support the housing market. Freddie Mac observed that HARP refinancers were shortening the duration of their loans[xii]. This suggests that the steepening Yield Curve, because of rising interest rate expectations, has caused a migration of borrowers down the Curve to find attractive borrowing rates. Since the overwhelming majority of refinancers (95%) locked in fixed rate loans, one can be certain that this was a forced migration in search of a lower current cost of financing. In migrating into shorter duration borrowing, the borrowers have increased their exposure to the risk of higher future interest rates at the next debt roll-over. Beggars cannot be choosers however; as it was their imperative need for lower current finance costs that forced them to take on this refinancing risk. The roll-over risk of the MBS associated with these underlying loans has also risen. Thus even though the risk in these bonds appears to have been reduced, through shortened duration, it has actually risen because borrowers rely on being able to refinance the existing loan with a new one in order to repay the principal on the existing loan. These risky short duration loans are GSE eligible, therefore they will be owned by the Fed. It is therefore no surprise that the Fed wishes to maintain a status quo, which creates the interest rate conditions which facilitate a smooth roll-over of the debt.
Fitch was noted in “Les Miserables”[xiii] trying to “quietly” make its “Bubble Call” on the housing market. Having dropped this bombshell, Fitch quietly lit the fuse[xiv]. The explosive is very clearly located at the former Countrywide mortgage portfolio, now owned by BofA. Fitch’s arcane discourse explained that the Judicial Foreclosure process is a lengthy one, which has had the impact of reducing the supply of homes. This convoluted Judicial Foreclosure thesis was supported by RealtyTrac[xv].
By inference, this latent supply has supported house prices as long as it has remained so. Unfortunately however, this latent supply is now hitting the market and negatively impacting prices. Allegedly, forty percent of this latent supply problem is located at BofA.
Further signs of indigestion in the housing market became evident in September, as the buying frenzy cooled[xvi]. Signs of the indigestion of the distressed housing debt pig, passing through the body of the python, emerged at the source of HUD. HUD recently admitted that in an auction of distressed mortgage debt, on October 30th, it was unable to sell $450 million of its deeply discounted FHA debt[xvii]. As with the case of the banks charging the Fed more in interest to increase its balance sheet risk, so the private sector is now charging a higher risk premium in order to buy distressed housing debt. The private market for credit is efficiently discounting the heightened credit risk and weaker economic backdrop that the back-up in interest rates has created. The situation has not evolved into Goldman’s infamous “Big Short” yet though; it is more a case that the price discount for the “Big Long” has increased. Investors are having their cake and eating it, in terms of demanding greater compensation for accepting the inevitable increase in the size of the Fed’s Balance Sheet and extended period of low interest rates. Appetite for the “Big Long” has been increased by the arrival of Yellen and what she stands for; but she will now be charged a higher risk premium for her intentions and capabilities. Bill Ackman showed that the commitment and faith remains strong, with his announcement of nearly ten percent stakes in Freddie Mac and Fannie Mae[xviii]. As an “Activist Investor” he clearly feels that he can command even further concessions from the Federal “management” of Freddie and its liquidity provider at the Fed. Why else would he expose his investors to a housing market that is starting to unravel? Through his actions, Ackman has shown his belief in the mediocrity of the American economy failing to create new income generating opportunities. He has been forced into the risky deep end of the shrinking asset pool; and now requires the monetary and fiscal authorities to bail him out.
It is becoming clear whom the survivors will be in the next housing crisis. Clearly the Fed intends to protect itself, the GSE’s whose bonds it owns and the banks that are members of the Federal Reserve System who create the mortgages that the Fed buys. The investment banks are obviously not inside this circle of trust; which is why Moody’s recently downgraded them[xix]. In Terminal Velocity (29) “The Real Prize”[xx] it was suggested that the Fed would attempt to select the winners, by expanding its balance sheet to assert control of the trading in Oil. Janet Yellen gave further evidence of her intentions and capabilities to pursue this objective last week[xxi]. It was presented innocently enough as the attempt to prevent event risk, “such as an oil spill”, undermining financial stability via banks with exposure to the physical Oil markets. By allegedly anticipating an external shock, the Fed is conveniently asserting control of the market. Surely the best way to insulate the financial system would be to prevent the banks from being involved in the trading of Oil altogether; and simply limiting them to the financing of the trading in Oil. Yellen gave no indication that the banks would be banned from either of these activities; only that these activities would be regulated by the Fed going forward. By allowing the banks to trade in Oil and finance its trading, clearly the Fed intends to control how it will be traded. In an environment where the Fed requires economic mediocrity, in order to remain solvent, the risk of insolvency presented by uncontrolled Oil prices is a risk that needs mitigating. Low Oil prices mean low inflation; and hence the reason to remain accommodative.