Wednesday, October 20, 2010
We have woken up ths morning to find our desks covered in "relax, don't worry, the correction is over" pieces. But TMM think too many technical supports have cracked so we are not jumping on this renewed USD sell fest. There is too much relief at the relief. Instead we are waiting for the still-overweight droids to respond to their rolling momentum models and continue to buy USDs back. Even if Voldemort and his death eaters are currently happy to take the other side. So whilst waiting for the second showing of the "path of most pain" TMM will have a look at a subject we have thus far kept pretty quiet on. The whole Mortgage-gate thing. And this headline yesterday was just too much to let it go:
BOFA CEO MOYNIHAN SAYS BANK WILL PROTECT SHAREHOLDERS AGAINST MORTGAGE INVESTORS WHO SAY "I BOUGHT A CHEVY VEGA, BUT I WANT IT TO BE A MERCEDES"
TMM is led to believe by the mortgage experts that losses related to put-backs could come as high as $100bn, but a good chunk - perhaps 50% of GSE put-backs - of these losses have already been taken. In the grand scheme of things, that is not a particularly large number (anyone remember the time when a $2bn loss would move Spooz 2%...?! How things have changed...), and unlikely to result in further capital needs at the banks. But TMM, like many others, was particularly surprised to see that the NY Fed, along with PIMCO, is attempting to put-back a good chunk of mortgages to Bank of America. Now, this is quite a big deal as far as TMM are concerned, as not only have the two largest buyers of mortgages decided to try and get some money back, but one of them is the Fed. Apologies for the cliché, but don't fight the Fed. BoA is going to take a bath on this. But, as above, that's not the real problem here, as this is just transferring cash from one group to another.
The *real* problem, in TMM's view, is the impact upon the securitisation machine going forward. Now, after the tumult of the past few years, the machine was not really in great shape anyway. TMM suspect that the legal and administrative nightmare that has arisen will result in significant changes to the originate-to-distribute model above and beyond those that have already been implements post-crisis. Securitisation was conceived because it was thought that it would (a) reduce the risk to investors by providing embedded diversification, and (b) allow banks to move assets off balance sheet in order to extend more credit without being exposed to the existing loans. Well it turns out that it has failed on both fronts, both in the form of concentrated losses, and the complex paperwork attached to securitisation resulting in loans coming back on balance sheet at Par. It doesn't look so smart now, does it?
That's not to say securitisation is a bad thing, it has clearly had the intended benefits, just not to the degree to which originally conceived. But going forward, it seems that an additional administrative overhead as a result of Mortgage-gate will be put on the process, slowing the machine down and reducing the amount of credit extended. To TMM, that sounds like the Velocity of Money is going to take a further hit at a time when it has already fallen hard as result of the crisis. TMM have generally been pretty optimistic in terms of the amount of deleveraging needed, and the amount of progress made to date, but this gives cause to re-asses. The below chart shows the logarithm of the ratio of debt outstanding to M2 for Households (white line), Household Mortgage debt (brown line) and Corporate (yellow line). Post DotCom crash, corporates deleveraged aggressively and, as evidenced by the very large amount of cash held on balance sheets, are underleveraged with respect to the long-run trend. As the story goes, households just kept leveraging at unsustainable rates and have a lot to do. Of course, the amount of deleveraging is determined by how much of the financial innovation over the past 30yrs has permanently affected the velocity of money, and how much of that is gone forever more.
TMM can see four potential scenarios, with current market expectations lying somewhere in between numbers 1) and 2):
- The jump in household leverage post 2001 was purely due to the shadow banking system and related mortgage bubble. If it is only that portion of velocity that is being unwound, then eyeballing the below chart, there is probably another ~10% to go, and the post-Smithsonian Agreement trend (see chart below, green line)) is probably intact. This is the optimistic scenario.
- The originate-to-distribute model is severely impaired, there is a disintermediation of credit led by banks moving away from securitisation as their primary means of extending credit. The velocity of money falls further and the financial system moves to a hybrid securitisation plus more European-style bank-based one. In this scenario, it is reasonable to conclude that much of the developments in credit markets since the mid-1990s are reversed and the sustainable ratio for household debt moves down towards the pre-1994 trend (see chart below, red line), which implies something like a further 25% fall in household leverage. This is the bearish scenario.
- On top of the above, households develop an aversion to debt, Glass-Stegal returns either explicitly, or by default as a result of bank behaviour. Virtually all the innovation gains of the past 30yrs are wiped out and the economy turns Japanese. The ratio falls towards its pre-1983 trendline (see chart below, white line), by about 33%. This is the uber-bearish scenario of the Roubinis of the World.
- But TMM think there is another scenario, that will be music to the Gold Bugs' ears. Prior to the 1971 Smithsonian agreement, the Gold Exchange Standard effectively limited credit extension and the velocity of money. One of the more conspiracy-related extensions of the current chatter regarding a global agreement on currencies is that the QE enacted by the Fed will eventually become a permanent part of their balance sheet. The argument goes that policymakers want Gold to go up to $2500 at which point the Gold on the Fed's balance sheet will be re-valued, and the currency backed by 1/3rd Gold as part of a basket, i.e. - the monetary system moves back to something like it was pre-1971. Now under the rigidities of such a monetary system, it might be expected that the sustainable ratio would have to fall to the pre-1971 trend (pink line), by something like 40%. Of course, as a result of the QE being permanent, much of this adjustment will have been made by the denominator of the equation, rather than the numerator...
...and then TMM took off their Tin Foil Beanies...
Back to Mortgage-gate. TMM think that the ultimate scenario lies somewhere between 1) and 2), but closer to the former than the latter. The trouble is that the repercussions of Mortgage-gate are to move us a little closer to the second scenario. In that respect, at least, scandal is something of a growth shock.