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How much? HOW MUCH?????
Jan. 25th, 2011 02:59 pmA couple of years ago I wrote something on a matter that no-one at the time wanted to talk about -- just how much money had really gone up the Swannee in the US as a result of faulty lending?
This is not an easy number to establish, in that it requires certain assumptions on what loans were bad and how bad the bad loans will turn out to be. What made it harder to establish was that an awfully large number of parties (led by Hank Greenberg at AIG) wanted to insist that in the long run the "loss" would be much lower than others were claiming.
I think that I came up with a figure of something in the region of $250bn (in the US alone) -- which sounds like an awful lot and, well, IS an awful lot, since it comes to more than a thousand dollars for every adult in the US. It's also about four to five times the economic impact of hurricane Katrina. And tied to this is that other countries have also been hit so, unlike with Katrina, there isn't international capital (via, in Katrina's case, international reinsurers) available to help out.
But in other ways it isn't an awful lot. Compared to the per capita debt in Ireland and Iceland it's peanuts. It's even small compared to the real (but as yet unacknowledged) per capita debt in Spain. Given that the US produces a hell of a lot of "stuff", it can produce its way out of trouble.
Unfortunately it doesn't seem to be keen on producing its way out of trouble. It would rather consume its way out of trouble ('twas ever thus) and is at the moment issuing inflation-proofed debt (my one-time favourite product TIPS) at an ever-increasing rate. Some $125bn this year apparently. While index-linked debt is "good" for buyers, it isn't so good for sellers (the Treasury), because it eliminates an easy way to get out of trouble -- to inflate away the debt.
Even in the UK the ability of the Treasury to inflate away debt has been drastically reduced in the past 30 years. Inflation-proofed pensions, gilts, pension guarantees, etc, all serve to dilute the impact of inflation -- to the extent that countries, paradoxically, have to reduce the value of money even more to get themselves out of trouble.
The other alternative is even more frightening, in that inflation-proofed debt bears an uncanny similarity to Equitable Life's Guaranteed Annuity Rates. The assumption is that the provider will be able to afford to pay. But if the money issuers run out of the means to get themselves out of trouble, that makes default more likely, not less. Simply by "guaranteeing" one side of the bond (the "value" part) you do not reduce the risk of the bond as a whole. You just shift the risk to the "default" part. Rather than losing a proportion of your investment (as in a standard bond with inflation), you either lose nothing or you lose all of it. Not quite my definition of a "safer" product, to be honest.
No investment advisers I know of seem to have spotted this point.
Anyhoo, back to the $250bn "real" loss. What is happening now in the US is a debate on who should pay. There were $1.4trn in mortgage=-backed securities in play when the disaster hit. Let's assume, for the sake of argument, that $250bn of these will go bad. At the moment most of the players seem to be too optimistic about their own share of the mess. This is not unusual. After Katrina you would often get an uinsurer assuming that it would make, say $200m of recovery, while the reinsurer would assume that it would only have to pay out, say, $100m. Only as the year went on and the lawyers earnt more and more money did the true liability become clear.
This is what will happen with the subprime mortgages. Bank of America's current assumed liability of $7bn to $10bn will turn out to be too low. Pension funds that assume they will make a 100% recovery and are leaving that number as such on their books will in fact only get, say, 60% back, leaving a gaping hole in their finances.
For the moment both sides can live with the self-deception. Indeed, they cannot afford NOT to live with the self-deception, because (see the Cajas/Caixas in Spain/Catalonia) if they face up to reality, then they are insolvent and they would have to stop trading. The fiction, and the hope that, in the next few years, "something will turn up" is actually vital for the current banking system to carry on operating.
This is all a bit frightening; we have to assume a fiction so that our whole financial edifice can try to trade itself out of trouble. It's a bit like putting Neil Blatchly in charge of economic recovery. And yet, and yet, it might work. One thing which is coming to the rescue is the restoration of margins (the gap between what the banks pay savers and what they charge lenders). When you pay savers nothing, that slowly gets rid of some of the problem. Elsewhere, you have the aforementioned inflation. Although this too hurts savers vs lenders, it's a slightly different matter, referring as it does to real interest rates rather than the gap between saving rates and lending rates.
Thirdly you have a little bit, just a little bit, of common sense in the world of saving vs consuming. The west is putting together a slightly higher savings ratio, the developing world seems to be developing a slightly lower savings ratio.
As you can see, this is no "grand solution" -- it's all a hodge-podge-fudge-pudge of a bit here and bit there. And there will be further casualties along the way. China at the moment appears to be a bit of a seventh cavalry for the euro, being prepared to save the currency in return for political and economic influence (worrying that it is using a strategy that it refined in Africa in decades past).
Oh well. More work.
______________
This is not an easy number to establish, in that it requires certain assumptions on what loans were bad and how bad the bad loans will turn out to be. What made it harder to establish was that an awfully large number of parties (led by Hank Greenberg at AIG) wanted to insist that in the long run the "loss" would be much lower than others were claiming.
I think that I came up with a figure of something in the region of $250bn (in the US alone) -- which sounds like an awful lot and, well, IS an awful lot, since it comes to more than a thousand dollars for every adult in the US. It's also about four to five times the economic impact of hurricane Katrina. And tied to this is that other countries have also been hit so, unlike with Katrina, there isn't international capital (via, in Katrina's case, international reinsurers) available to help out.
But in other ways it isn't an awful lot. Compared to the per capita debt in Ireland and Iceland it's peanuts. It's even small compared to the real (but as yet unacknowledged) per capita debt in Spain. Given that the US produces a hell of a lot of "stuff", it can produce its way out of trouble.
Unfortunately it doesn't seem to be keen on producing its way out of trouble. It would rather consume its way out of trouble ('twas ever thus) and is at the moment issuing inflation-proofed debt (my one-time favourite product TIPS) at an ever-increasing rate. Some $125bn this year apparently. While index-linked debt is "good" for buyers, it isn't so good for sellers (the Treasury), because it eliminates an easy way to get out of trouble -- to inflate away the debt.
Even in the UK the ability of the Treasury to inflate away debt has been drastically reduced in the past 30 years. Inflation-proofed pensions, gilts, pension guarantees, etc, all serve to dilute the impact of inflation -- to the extent that countries, paradoxically, have to reduce the value of money even more to get themselves out of trouble.
The other alternative is even more frightening, in that inflation-proofed debt bears an uncanny similarity to Equitable Life's Guaranteed Annuity Rates. The assumption is that the provider will be able to afford to pay. But if the money issuers run out of the means to get themselves out of trouble, that makes default more likely, not less. Simply by "guaranteeing" one side of the bond (the "value" part) you do not reduce the risk of the bond as a whole. You just shift the risk to the "default" part. Rather than losing a proportion of your investment (as in a standard bond with inflation), you either lose nothing or you lose all of it. Not quite my definition of a "safer" product, to be honest.
No investment advisers I know of seem to have spotted this point.
Anyhoo, back to the $250bn "real" loss. What is happening now in the US is a debate on who should pay. There were $1.4trn in mortgage=-backed securities in play when the disaster hit. Let's assume, for the sake of argument, that $250bn of these will go bad. At the moment most of the players seem to be too optimistic about their own share of the mess. This is not unusual. After Katrina you would often get an uinsurer assuming that it would make, say $200m of recovery, while the reinsurer would assume that it would only have to pay out, say, $100m. Only as the year went on and the lawyers earnt more and more money did the true liability become clear.
This is what will happen with the subprime mortgages. Bank of America's current assumed liability of $7bn to $10bn will turn out to be too low. Pension funds that assume they will make a 100% recovery and are leaving that number as such on their books will in fact only get, say, 60% back, leaving a gaping hole in their finances.
For the moment both sides can live with the self-deception. Indeed, they cannot afford NOT to live with the self-deception, because (see the Cajas/Caixas in Spain/Catalonia) if they face up to reality, then they are insolvent and they would have to stop trading. The fiction, and the hope that, in the next few years, "something will turn up" is actually vital for the current banking system to carry on operating.
This is all a bit frightening; we have to assume a fiction so that our whole financial edifice can try to trade itself out of trouble. It's a bit like putting Neil Blatchly in charge of economic recovery. And yet, and yet, it might work. One thing which is coming to the rescue is the restoration of margins (the gap between what the banks pay savers and what they charge lenders). When you pay savers nothing, that slowly gets rid of some of the problem. Elsewhere, you have the aforementioned inflation. Although this too hurts savers vs lenders, it's a slightly different matter, referring as it does to real interest rates rather than the gap between saving rates and lending rates.
Thirdly you have a little bit, just a little bit, of common sense in the world of saving vs consuming. The west is putting together a slightly higher savings ratio, the developing world seems to be developing a slightly lower savings ratio.
As you can see, this is no "grand solution" -- it's all a hodge-podge-fudge-pudge of a bit here and bit there. And there will be further casualties along the way. China at the moment appears to be a bit of a seventh cavalry for the euro, being prepared to save the currency in return for political and economic influence (worrying that it is using a strategy that it refined in Africa in decades past).
Oh well. More work.
______________
