Think of it as a picture guide to the ongoing earthquake in the world of high finance. Through charts, graphs, and tables, we will try to understand the dimensions of the current financial crisis--its origins and causes, its likely consequences, its potential remedies.
In seeking to understand the crisis, we need to begin with the credit mechanism. We are living through the bust of one of the greatest credit cycles of all financial history. In order get a handle on the seriousness of the bust, we must register the mania that fed the boom.
I look first at some measures indicative of the financial turmoil. For those unfamiliar with the financial markets, this provides a birds-eye view of the most important indicators, together with links for fresh updates.
The next three sections deal with the causes of the crisis, in which we examine the role of the housing boom and bust, the general growth of credit market debt, and the explosion in derivatives. The general pitch here is that the crisis has arisen above all from the extremities of debt and leverage that built up in the financial system over a long period.
Then it’s on to a consideration of consequences and remedies. The basic question--how much insolvency exists within the financial system?--is vital in assessing the wisdom of various bailouts and rescues, the opportunity costs associated with the government-mandated maintenance of the "FIRE" sector (Financials, Insurance, Real Estate), and how the global imbalances that have marked the last fifteen years are likely to change.
I conclude with some lessons and a collection of paper topics for interested students to consider.
The presentation is generally pitched to the intelligent undergraduate who doesn't know much but is eager to learn. Though prepared for anyone who believes, with me, that a chart is worth a thousand words, I put it together with my students primarily in mind. It began as a 25 minute presentation at Colorado College, then grew.
The whole financial crisis now ongoing must appear as fundamentally bewildering to young people, they who just assumed that their parents' generation knew what it was doing. Alas, no. Understanding what is going on is itself very difficult; finding the right answers is a huge challenge. These are notes and fragments to further that undertaking.
There are two ways of navigating this site: through the "Labels" section, which presents each chapter in an orderly fashion, or through the Table of Contents below.
10/30/08
10/18/08
Table of Contents
INTRODUCTION
--The Overall Idea
--Table of Contents
--Summary of Argument
--Updates and Acknowledgments
FINANCIAL STRESS
--Doom Is Busting Out All Over
--World Stock Market Capitalization Crumbles
--Twin Peaks
--Stock Market Volatility
--High Yield Bonds Over 20%
--High Yield Credit Spreads Top Levels of 2003
--AAA Corporate Bonds: Compared to What?
--LIBOR and Financial Stress
--Flame-Broiled Mortgage Spreads
--TED Spread from 1980s
--Commodities Tank
--Consumer Credit Crashing
--One Big Happy Human Family
--The Banking System: The Issue of Trust
--Carry Trades Unwinding
--Measuring Inflation
--Unemployment Mythologies and the "Misery Index"
--If You Want More,
--Minsky Moments
HOUSING BUBBLE
--California at Height of Bubble
--In the Long Run We're All Dead
--Financial Firm Profitability and Real Estate
--The Big House
--Regional Variation in Housing Declines
--US Homeowners with No or Negative Equity
--One in Six Homeowners Under Water
--Future Housing Prices
--Out of Whack: House Prices and Disposable Income
--Rent Ratios Mean Housing Will Fall Further
--A Cautionary Lesson from Japan
DEBT BINGE
--Total Credit Market Debt is Way High
--Debt to GDP from 1920s
--History is Not Bunk
--Profits of Financial Firms
--Debt Fueled the Equity Boom
--Margin Debt
--Consumer Debt Outstanding
--About That Loan
--National Debt as Percent of GDP (from 1950)
--The Two National Debts
--Understated Obligations
--Stairway to Heaven: Yet More Unfunded Obligations
--Total US Debt and US Debt/World Equity Ratio
--2009 Deficit to $2 Trillion, 12.5% of GDP
--Maxims on Debt and Credit
DERIVATIVES JUNGLE
--One More Bad Thing
--Credit Default Swamps
--Happiness Through Bilateral Netting
--The Mothership of the Derivatives Structure: JP Morgan Chase
--Leverage Ratios at European Banks
--Leverage Unbound at the Investment Banks
--Slicing and Dicing Those Damn Derivatives
SCALE OF LOSSES
--Estimates of Losses
--The Housing ATM and Losses on Real Estate
--Losses and Liquidity
--Preparing for a Rainy Day?
--House Debt as Percent of Compensation
--The Importance of Being Credit-Worthy
--A Comparison with Japan
RESCUES AND REMEDIES
--Deteriorating Balance Sheet at the Fed
--The Greatest Bailout of Them All
--Cash for Trash: The Fed's Balance Sheet
--Paulson Plan, circa October 14, 2008
--Zingales is a Hero; Paulson is a Lout
--The Major Scandal
--Last Resort
--Poor Goldman Sachs
--The Grand Alternative
--The US Hedge Fund and the Bond Conundrum
--Uncle Sam's Adjustable Rate Mortgage
--Twin Towers
GLOBAL IMBALANCES
--Crazy World Order
--Deficit on Current Account Contracting
--Our Best Friends: Foreign Central Banks
--Flight to Quality by Foreign Central Banks
--The End of Bretton Woods II
--The Linked Dangers Foretold (Sort Of)
LESSONS
--Six Lessons from the Financial Crisis
--Implications for "Defense"
--Joseph Stiglitz Excoriates Economists
--Paper Topics
--The Ten Commandments
--The Ten Steps
--Further Reading
--Man, Did I Screw Up
--We Value What We Save in a Crisis
--The Overall Idea
--Table of Contents
--Summary of Argument
--Updates and Acknowledgments
FINANCIAL STRESS
--Doom Is Busting Out All Over
--World Stock Market Capitalization Crumbles
--Twin Peaks
--Stock Market Volatility
--High Yield Bonds Over 20%
--High Yield Credit Spreads Top Levels of 2003
--AAA Corporate Bonds: Compared to What?
--LIBOR and Financial Stress
--Flame-Broiled Mortgage Spreads
--TED Spread from 1980s
--Commodities Tank
--Consumer Credit Crashing
--One Big Happy Human Family
--The Banking System: The Issue of Trust
--Carry Trades Unwinding
--Measuring Inflation
--Unemployment Mythologies and the "Misery Index"
--If You Want More,
--Minsky Moments
HOUSING BUBBLE
--California at Height of Bubble
--In the Long Run We're All Dead
--Financial Firm Profitability and Real Estate
--The Big House
--Regional Variation in Housing Declines
--US Homeowners with No or Negative Equity
--One in Six Homeowners Under Water
--Future Housing Prices
--Out of Whack: House Prices and Disposable Income
--Rent Ratios Mean Housing Will Fall Further
--A Cautionary Lesson from Japan
DEBT BINGE
--Total Credit Market Debt is Way High
--Debt to GDP from 1920s
--History is Not Bunk
--Profits of Financial Firms
--Debt Fueled the Equity Boom
--Margin Debt
--Consumer Debt Outstanding
--About That Loan
--National Debt as Percent of GDP (from 1950)
--The Two National Debts
--Understated Obligations
--Stairway to Heaven: Yet More Unfunded Obligations
--Total US Debt and US Debt/World Equity Ratio
--2009 Deficit to $2 Trillion, 12.5% of GDP
--Maxims on Debt and Credit
DERIVATIVES JUNGLE
--One More Bad Thing
--Credit Default Swamps
--Happiness Through Bilateral Netting
--The Mothership of the Derivatives Structure: JP Morgan Chase
--Leverage Ratios at European Banks
--Leverage Unbound at the Investment Banks
--Slicing and Dicing Those Damn Derivatives
SCALE OF LOSSES
--Estimates of Losses
--The Housing ATM and Losses on Real Estate
--Losses and Liquidity
--Preparing for a Rainy Day?
--House Debt as Percent of Compensation
--The Importance of Being Credit-Worthy
--A Comparison with Japan
RESCUES AND REMEDIES
--Deteriorating Balance Sheet at the Fed
--The Greatest Bailout of Them All
--Cash for Trash: The Fed's Balance Sheet
--Paulson Plan, circa October 14, 2008
--Zingales is a Hero; Paulson is a Lout
--The Major Scandal
--Last Resort
--Poor Goldman Sachs
--The Grand Alternative
--The US Hedge Fund and the Bond Conundrum
--Uncle Sam's Adjustable Rate Mortgage
--Twin Towers
GLOBAL IMBALANCES
--Crazy World Order
--Deficit on Current Account Contracting
--Our Best Friends: Foreign Central Banks
--Flight to Quality by Foreign Central Banks
--The End of Bretton Woods II
--The Linked Dangers Foretold (Sort Of)
LESSONS
--Six Lessons from the Financial Crisis
--Implications for "Defense"
--Joseph Stiglitz Excoriates Economists
--Paper Topics
--The Ten Commandments
--The Ten Steps
--Further Reading
--Man, Did I Screw Up
--We Value What We Save in a Crisis
Summary of Argument
The world financial system is undergoing a kind of seizure, with assets crashing more wildly than they have done since the Great Depression. At the core of the crisis is the mayhem in the credit markets, where interest rates are going up sharply. The popping of the housing bubble has brought to dramatic pitch the unsustainable levels of US debt across wide sectors (not just housing). The extreme leverage on dodgy assets characteristic of US and European financial institutions has made many of them insolvent if their assets are judged on a “mark-to-market” basis. Various signs point to a deep recession, at a minimum, possibly much worse.
The financial crisis will have extraordinary implications for just about everything. It marks the birth of a new era quite as much as 9/11 did. We need to reflect about the lessons, nearly all of which are rather grim, and start asking in earnest about the political and economic consequences.
I give US authorities very low marks in their response to the financial crisis. Paulson and Bernanke have mistakenly characterized the crisis as a liquidity rather than solvency issue. They have also failed to introduce any coherent limit on the government’s acquisition of toxic private debt. The Paulson Plan is especially wrong-headed, as being neither equitable to the taxpayer nor efficacious in its stated aim (getting banks to lend again). The commitment of public funds to insolvent institutions must have shareholder wipeouts and debt-to equity conversions as a basic feature. The real bill of the US government’s strategy has been minimized in a kind of shell game, but the opportunity costs will likely prove tremendous. There is much cause for depression in both the terrifying implications of an economic collapse and in the response of US authorities to the crisis.
10/26/08
The financial crisis will have extraordinary implications for just about everything. It marks the birth of a new era quite as much as 9/11 did. We need to reflect about the lessons, nearly all of which are rather grim, and start asking in earnest about the political and economic consequences.
I give US authorities very low marks in their response to the financial crisis. Paulson and Bernanke have mistakenly characterized the crisis as a liquidity rather than solvency issue. They have also failed to introduce any coherent limit on the government’s acquisition of toxic private debt. The Paulson Plan is especially wrong-headed, as being neither equitable to the taxpayer nor efficacious in its stated aim (getting banks to lend again). The commitment of public funds to insolvent institutions must have shareholder wipeouts and debt-to equity conversions as a basic feature. The real bill of the US government’s strategy has been minimized in a kind of shell game, but the opportunity costs will likely prove tremendous. There is much cause for depression in both the terrifying implications of an economic collapse and in the response of US authorities to the crisis.
10/26/08
Updates and Acknowledgments
While I have heard the term “blogbook,” I don’t recall having seen one, despite having spent a good part of my existence in the last six years “surfing the web.” By a blogbook I mean something that, utilizing blogging technology, is to be approached as a book, with a chapter organization and such.
Google's webhosting service, Blogspot, is not made for blogbooks, though it is easily adaptable to that purpose. But one note of caution: Ordering within each of the chapters depends on time of posting, so my time stamps are not necessarily indicative of the actual time the material was posted. I have altered them to allow for an orderly presentation. The initial foray of posts was made in mid-October 2008, and the time-stamps will stay ordered in that time frame; since then, I have mostly been updating with links for further reading. When I make a substantive change to a post, I will signify that by a date at the bottom of the entry indicating the date of the latest update.
Doing a blogbook is an odd writing experience. My normal method is to write something, then fiddle with it endlessly. I always think I’m done, but this invariably proves an illusion. I’m never quite done. I have also found that I have to post something several times before I correct all the typos and haywire formatting. That’s fine if you’re writing a book and no one is reading it, but odd if you’re doing your composition and revision in plain view.
A great many websites that contain charts like those appearing here are in the business of investment advice. They are basically trying to figure out which way the various asset classes are going to move—up or down?—and they attract readers because they help answer the question: where should I put my money?
I do not find that an obnoxious question; I have devoted considerable time, not necessarily well spent, to thinking about that very thing. But the focus of Cause for Depression is otherwise. The question that it asks is not: how is the investor or future pensioner to survive in the coming turmoil? Instead, the focus is on public affairs. What is the nature of the crisis that government must address? Has it responded judiciously to the crisis? What lessons for financial governance may we draw from the experience? What are the implications for the world economic and financial system? I don’t pretend to exhaust these subjects, but they and questions like them are what draw my primary interest in this presentation.
My deeper interest, though one that is barely registered here, is with the implications for American foreign policy. What will be the features of the new era that has now suddenly fallen upon us? How should the nation adapt? The nexus between the financial crisis, on the one hand, and our energy and environmental problems, on the other, also excites my rapt attention. I hope to get to those one of these days.
While I would sincerely like to go to a place where the words “finance” or “derivatives” were never uttered, I will probably keep updating, mostly with links to new information and developments. The financial crisis is a hell of a lot more exciting than baseball, if you ask me, but it does have the aspect of watching a not-so-slow-motion train wreck. Repellent, but enthralling! And very consequential.
When possible, I’ve tried to indicate where to find updated sources of information for the material presented here. Given my harsh view of "derivatives," I'm obliged to say that this compendium is almost entirely derivative. I’m deeply indebted to my blogroll for ideas, inspiration, and many of the charts contained herein.
If you are intrigued by what you find here, my idea for further research is pretty straightforward: Just put my blogroll into your Google Reader, and follow along with Yves, Tim, Mish, Jesse, Mike, Barry, Willem, and the rest as they illuminate the great transformation now occurring.
10/25/08
Google's webhosting service, Blogspot, is not made for blogbooks, though it is easily adaptable to that purpose. But one note of caution: Ordering within each of the chapters depends on time of posting, so my time stamps are not necessarily indicative of the actual time the material was posted. I have altered them to allow for an orderly presentation. The initial foray of posts was made in mid-October 2008, and the time-stamps will stay ordered in that time frame; since then, I have mostly been updating with links for further reading. When I make a substantive change to a post, I will signify that by a date at the bottom of the entry indicating the date of the latest update.
Doing a blogbook is an odd writing experience. My normal method is to write something, then fiddle with it endlessly. I always think I’m done, but this invariably proves an illusion. I’m never quite done. I have also found that I have to post something several times before I correct all the typos and haywire formatting. That’s fine if you’re writing a book and no one is reading it, but odd if you’re doing your composition and revision in plain view.
A great many websites that contain charts like those appearing here are in the business of investment advice. They are basically trying to figure out which way the various asset classes are going to move—up or down?—and they attract readers because they help answer the question: where should I put my money?
I do not find that an obnoxious question; I have devoted considerable time, not necessarily well spent, to thinking about that very thing. But the focus of Cause for Depression is otherwise. The question that it asks is not: how is the investor or future pensioner to survive in the coming turmoil? Instead, the focus is on public affairs. What is the nature of the crisis that government must address? Has it responded judiciously to the crisis? What lessons for financial governance may we draw from the experience? What are the implications for the world economic and financial system? I don’t pretend to exhaust these subjects, but they and questions like them are what draw my primary interest in this presentation.
My deeper interest, though one that is barely registered here, is with the implications for American foreign policy. What will be the features of the new era that has now suddenly fallen upon us? How should the nation adapt? The nexus between the financial crisis, on the one hand, and our energy and environmental problems, on the other, also excites my rapt attention. I hope to get to those one of these days.
While I would sincerely like to go to a place where the words “finance” or “derivatives” were never uttered, I will probably keep updating, mostly with links to new information and developments. The financial crisis is a hell of a lot more exciting than baseball, if you ask me, but it does have the aspect of watching a not-so-slow-motion train wreck. Repellent, but enthralling! And very consequential.
When possible, I’ve tried to indicate where to find updated sources of information for the material presented here. Given my harsh view of "derivatives," I'm obliged to say that this compendium is almost entirely derivative. I’m deeply indebted to my blogroll for ideas, inspiration, and many of the charts contained herein.
If you are intrigued by what you find here, my idea for further research is pretty straightforward: Just put my blogroll into your Google Reader, and follow along with Yves, Tim, Mish, Jesse, Mike, Barry, Willem, and the rest as they illuminate the great transformation now occurring.
10/25/08
10/17/08
Doom is Busting Out All Over
2008 will go down as one of the wildest years in financial history, having witnessed two huge earthquakes that have reordered the political and economic landscape, just as surely as the collapse of the twin towers did on 9/11/2001.
One shock in 2008 was the meteoric rise in energy prices, which crested just shy of $150 a barrel in the summer, followed by an equally bloodcurdling descent. Whole US industries--airlines, trucking, housing, autos--responded in the summer with a near death experience.
Following this oil shock was the cratering of various markets in September and October, which brought to a sudden new intensity the bear market in just about everything that began in the last part of 2007. Commodities, seemingly exempt, succumbed in August after oil prices peaked in July. Emerging markets crashed. Europe crashed. Latin America crashed. Asia crashed. And, of course, so did the good ole' USA.
The dark specter--a return of another Great Depression--seemed suddenly to be decidedly more than a remote possibility. It would be a capital historical irony for that to happen, for US officials have for three generations taken the avoidance of that experience as their lodestar. At least, that is what they thought they were doing. Yet there it was again, big as life and twice as ugly, baying at the door.
Scary times.
The charts that follow in this chapter on financial stress provide a sketch of the havoc now ongoing. Then we'll look to causes, consequences, and remedies.
One shock in 2008 was the meteoric rise in energy prices, which crested just shy of $150 a barrel in the summer, followed by an equally bloodcurdling descent. Whole US industries--airlines, trucking, housing, autos--responded in the summer with a near death experience.
Following this oil shock was the cratering of various markets in September and October, which brought to a sudden new intensity the bear market in just about everything that began in the last part of 2007. Commodities, seemingly exempt, succumbed in August after oil prices peaked in July. Emerging markets crashed. Europe crashed. Latin America crashed. Asia crashed. And, of course, so did the good ole' USA.
The dark specter--a return of another Great Depression--seemed suddenly to be decidedly more than a remote possibility. It would be a capital historical irony for that to happen, for US officials have for three generations taken the avoidance of that experience as their lodestar. At least, that is what they thought they were doing. Yet there it was again, big as life and twice as ugly, baying at the door.
Scary times.
The charts that follow in this chapter on financial stress provide a sketch of the havoc now ongoing. Then we'll look to causes, consequences, and remedies.
Six Lessons From the Financial Crisis
1. The conclusion seems irresistible that the defenders of capitalism proved its undoing. The most zealous proponents of free markets put them at profound risk. The financial institutions that stood at the epicenter of the world economic order proved to be based on a scam, at the center of which was the privatization of profit and the socialization of risk. Capital markets whose fundamental rationale was the most efficient allocation of scarce resources for investment failed miserably in their basic function. The most egregious rates of executive compensation ever produced the biggest failures of economic leadership ever. To those of us with a sentimental attachment to free markets as against command economies, all this is a blow.
2. We are made aware of how grave a responsibility is the management of a country’s currency. Money and credit are like oxygen; taken for granted in most circumstances, but when withdrawn inducing asphyxia. In terms of economic theory, the whole experience bears out the vital importance the Austrian economists placed on the credit cycle and underlines their skepticism toward fractional reserve banking. This is not to urge a return to the gold standard, but it is to urge derision and contempt upon those who constructed the house of cards and who ignored its vulnerabilities. There are many villains in the piece, but Alan Greenspan will surely stand out in retrospect as bearing the heaviest responsibility. Blithely indifferent to the dangers of debt and derivatives, he led us down the garden path.
3. We move inexorably toward the socialization of credit risk and a much larger role for the state in the direction of the national economy. Courtesy of Bush and Greenspan, Marx has made a comeback. In The Communist Manifesto, the fifth proposal in Marx’s ten point plan for placing the means of production in the hands of the proletariat was the “centralization of credit in the banks of the state, by means of a national bank with state capital and an exclusive monopoly.” Marx didn’t get it quite right; we’re getting there via the dictatorship of the kleptocracy. But hey, it's a start.
4. The collapse of America’s credit bubble is very likely to lead, both here and abroad, to the revival of various forms of national socialism. That is not a prediction of the revival of German National Socialism, but simply that the direction of economic affairs is likely to be swayed much more by the dictates of nationalist and socialist impulses. The Euro is especially vulnerable to the centrifugal forces unleashed by the crisis, with unfavorable consequences for the European experiment. Sheer cronyism may win out over state socialism, to be sure, and financial internationalism will battle to survive against the reassertion of nationalism. Still, I wouldn't underestimate the power of nationalist and socialist tendencies in the new era.
5. The opportunity cost of the financial bailout is huge. Moreover, insofar as it is based on the idea of reflating the financial, insurance, and real estate sectors (the FIRE economy), it is very dangerous to long term economic revitalization. The old Wall Street model is broken because most of the things they made money on (securitization, fees, leverage) turned out, in due time, to be based on a fundamental misapprehension of risk. Real estate remains overvalued by various traditional measures. A far more logical use of public resources is the tackling of our energy and environmental problems, both of them requiring large investments in infrastructure and alternative energy. We face the challenge of a generation in adapting to these challenges; the economic crisis, and the response given to it thus far, constitutes a formidable obstacle in doing so.
6. The financial crisis has opened up a great gap between our aspirations and resources. This must have profound implications for American foreign policy. We have a foreign policy more ambitious than that crafted in the heady days of unipolarity in the late 1990s, when observers marveled at the sheer surfeit of American power in its military, economic, ideological, and cultural dimensions. Though American power has weakened on every count, there is no reconsideration of objectives. The last thing that presidential candidates wish to do is to reconcile themselves to limits on American purposes. It goes entirely against the American grain, which treasures happy talk and fairy tales over the recognition of constraint. But finance is inexorable: it sets limits, diminishes horizons, induces constraint. Surely a profound adjustment in America's world role is coming.
2. We are made aware of how grave a responsibility is the management of a country’s currency. Money and credit are like oxygen; taken for granted in most circumstances, but when withdrawn inducing asphyxia. In terms of economic theory, the whole experience bears out the vital importance the Austrian economists placed on the credit cycle and underlines their skepticism toward fractional reserve banking. This is not to urge a return to the gold standard, but it is to urge derision and contempt upon those who constructed the house of cards and who ignored its vulnerabilities. There are many villains in the piece, but Alan Greenspan will surely stand out in retrospect as bearing the heaviest responsibility. Blithely indifferent to the dangers of debt and derivatives, he led us down the garden path.
3. We move inexorably toward the socialization of credit risk and a much larger role for the state in the direction of the national economy. Courtesy of Bush and Greenspan, Marx has made a comeback. In The Communist Manifesto, the fifth proposal in Marx’s ten point plan for placing the means of production in the hands of the proletariat was the “centralization of credit in the banks of the state, by means of a national bank with state capital and an exclusive monopoly.” Marx didn’t get it quite right; we’re getting there via the dictatorship of the kleptocracy. But hey, it's a start.
4. The collapse of America’s credit bubble is very likely to lead, both here and abroad, to the revival of various forms of national socialism. That is not a prediction of the revival of German National Socialism, but simply that the direction of economic affairs is likely to be swayed much more by the dictates of nationalist and socialist impulses. The Euro is especially vulnerable to the centrifugal forces unleashed by the crisis, with unfavorable consequences for the European experiment. Sheer cronyism may win out over state socialism, to be sure, and financial internationalism will battle to survive against the reassertion of nationalism. Still, I wouldn't underestimate the power of nationalist and socialist tendencies in the new era.
5. The opportunity cost of the financial bailout is huge. Moreover, insofar as it is based on the idea of reflating the financial, insurance, and real estate sectors (the FIRE economy), it is very dangerous to long term economic revitalization. The old Wall Street model is broken because most of the things they made money on (securitization, fees, leverage) turned out, in due time, to be based on a fundamental misapprehension of risk. Real estate remains overvalued by various traditional measures. A far more logical use of public resources is the tackling of our energy and environmental problems, both of them requiring large investments in infrastructure and alternative energy. We face the challenge of a generation in adapting to these challenges; the economic crisis, and the response given to it thus far, constitutes a formidable obstacle in doing so.
6. The financial crisis has opened up a great gap between our aspirations and resources. This must have profound implications for American foreign policy. We have a foreign policy more ambitious than that crafted in the heady days of unipolarity in the late 1990s, when observers marveled at the sheer surfeit of American power in its military, economic, ideological, and cultural dimensions. Though American power has weakened on every count, there is no reconsideration of objectives. The last thing that presidential candidates wish to do is to reconcile themselves to limits on American purposes. It goes entirely against the American grain, which treasures happy talk and fairy tales over the recognition of constraint. But finance is inexorable: it sets limits, diminishes horizons, induces constraint. Surely a profound adjustment in America's world role is coming.
10/16/08
Implications for "Defense"
The national security establishment has barely begun to register the severity of the financial crisis and what it may mean for American foreign and defense policy. The crisis has utterly disordered national finances. It will produce further cascading demands on the public treasury. Given these factors, the constraints on policy are going to be much more exacting than the national security establishment now believes. Defense will not prove to be “recession proof.”
Defining a coherent philosophy in foreign affairs and defense strategy that is respectful of limits is vital. Especially deserving of reconsideration are the grand plans to reorder the Middle East and Central Asia via military power, to make all the world democratic, to expand NATO to embrace Georgia and Ukraine, to threaten or undertake preventive war against suspected proliferators, and to bring the entire world under intimate surveillance. We could save a lot of money if we stopped trying to do what we’re not very good at doing anyway.
The defense establishment is like a huge ship that is difficult to turn and next to impossible to stop in its tracks. But serious savings could be had by reducing force structure and limiting modernization. The most important step is to repudiate the Bush Doctrine and to rivet US military power to defensive purposes. The ground forces, slated to expand, should be reduced.
Obama is seemingly not ready to do any of this. Biden is more hawkish than dovish and will reinforce the tendency toward business as usual. But stark financial constraints and the accompanying search for limits on external ambition will define Obama’s presidency; he needs to realize that sooner rather than later.
First posted: 11/02/08
Defining a coherent philosophy in foreign affairs and defense strategy that is respectful of limits is vital. Especially deserving of reconsideration are the grand plans to reorder the Middle East and Central Asia via military power, to make all the world democratic, to expand NATO to embrace Georgia and Ukraine, to threaten or undertake preventive war against suspected proliferators, and to bring the entire world under intimate surveillance. We could save a lot of money if we stopped trying to do what we’re not very good at doing anyway.
The defense establishment is like a huge ship that is difficult to turn and next to impossible to stop in its tracks. But serious savings could be had by reducing force structure and limiting modernization. The most important step is to repudiate the Bush Doctrine and to rivet US military power to defensive purposes. The ground forces, slated to expand, should be reduced.
Obama is seemingly not ready to do any of this. Biden is more hawkish than dovish and will reinforce the tendency toward business as usual. But stark financial constraints and the accompanying search for limits on external ambition will define Obama’s presidency; he needs to realize that sooner rather than later.
First posted: 11/02/08
California at Height of Bubble
The inflation and subsequent puncturing of the housing bubble has played a great role in the unfolding crisis. Housing is vital because it is the collateral behind a great deal of US debt. Essentially, a great pile of debt and derivatives was erected on a dubious foundation. A leader of the pack was California. With a little money down, which was still required at the beginning of the boom, and you could just print money.California, like Florida and Arizona, was an extreme case. But the mania was general. From 2000 to 2006, the total retail value of housing in the United States doubled, going from roughly $11 trillion to $22 trillion in just 6 years.
As of October 2008, the situation had deteriorated dramatically.
At the end of 2008, Mr. Mortgage delivered yet more New Year's glum in this table, which he calls "the scariest housing-related chart ever."
In the Long Run We're All Dead
This New York Times graphic shows the valuations of housing when a house was just a home (and not a vehicle for speculation).
Financial Firm Profitability and Real Estate
A vital source of the profitability of financial firms arose from mortgage-related assets, which includes both residential and commercial real estate. This graph, from Kevin Philip’s Bad Money, shows the importance of those toxic “mortgage related assets” to total earning power.
The Big House
This Financial Times chart, from March 2008, shows the close link between US equities and visits by prospective homebuyers. The housing data, from the National Association of Homebuilders, is advanced twenty months to show that housing is a leading indicator for the stock market and the economy.
Regional Variation in Housing Declines
Since the bubble burst, there has been plenty of regional variation in housing patterns. The worst hit areas are Phoenix, Las Vegas, Miami, San Diego and various other cities in California.
Calculated Risk, October 1, 2008
US Homeowners with No or Negative Equity
In this chart, Calculated Risk makes an estimate of the number of US homeowners with no or negative equity in their homes. At the end of 2008, according to CR, the figure is likely to be 15,433,000. If housing falls 30 percent from the peak, 20.5 million homeowners would be underwater; if it falls 35 percent from the peak, 23.4 million would have no or negative equity. How big the mortgage losses would be depends upon how many people walk away from their homes.
As Calculated Risk explains: "As of Q2 2008, prices had fallen almost 18% from the peak, and for the graph, I estimated that prices will decline about 22.5% from the peak by the end of 2008. (this seems conservative). This means about 15.4 million households will be underwater or already foreclosed on by the end of 2008.
The last two categories are based on various estimates for the price bottom (peak-to-trough). The 30% decline was suggested by Paul Krugman in December 2007: What it takes). The 35% decline is close to the "severe recession" case presented by JPMorgan last week.
Not every homeowner with negative equity will default, in fact many of these homeowners will only be underwater by a few percent. But if we estimate one half of homeowners with negative equity will eventually default, use a 50% loss severity, and a 35% price decline (23.6 million households with negative equity), and use the median house price from the Census Bureau of $216 thousand, we get $1.3 trillion in mortgage losses for lenders. I think this is probably high (probably fewer than 50% will default), but this does give a general idea of the potential losses.
If we use one third of homeowners, the mortgage losses with a 35% peak-to-trough price decline would be about $840 billion."
One in Six Homeowners Under Water
The Wall Street Journal reports that the fall in home prices "has left nearly one in six U.S. homeowners owing more on a mortgage than the home is worth, raising the possibility of a rise in defaults. . . . About 75.5 million U.S. households own the homes they live in. After a housing slump that has pushed values down 30% in some areas, roughly 12 million households, or 16%, owe more than their homes are worth, according to Moody's Economy.com.The comparable figures were roughly 4% under water in 2006 and 6% last year, says the firm's chief economist, Mark Zandi, who adds that 'it is very possible that there will ultimately be more homeowners under water in this period than any time in our history.'
Among people who bought within the past five years, it's worse: 29% are under water on their mortgages, according to an estimate by real-estate Web site Zillow.com." 10/08/08
World Stock Market Capitalization Crumbles
Click this link for an updated version of the Dow Jones World Stock Index. Math whizzes, please tell me how much it would be worth if it hit the lows of 2003.
This page from stockcharts can be used to see charts on a wide variety of other financial indices.
10/26/08
Twin Peaks
This lovely mountain view from Jesse's Café Américain gives the last twenty years of financial history at a glance. The chart was made on October 10, 2008. For more historical perspective, see the bear market interactive chart at the New York Times.
Stock Market Volatility
Stock market volatility in early October 2008 surged beyond any comparable level in the post 1945 era. Only the 1930s displays comparable mayhem. Bespoke Investment Group explains the above graph as follows: “Over the last month (23 trading days [since October 3, 2008]), the S&P 500 has seen 10 days where the index rose or fell (mostly fell) by more than 3%. You have to go all the way back to 1938 to find another one-month period where there were this many 3% days. As shown in the chart, there were many multi-year periods between 1950 and 2007 where the S&P 500 didn't have even one 3% day. If you're not a regular market participant and someone that is tells you we are experiencing something that hasn't happened since the Great Depression, they're not joking!”Kim Zussman, in "Mother of All Swans," has also put together a long term historical chart measuring volatility. Zussman used the daily returns of the Dow Jones Industrial Average from 1928 to early October 2008 and calculated the standard deviation for every non-overlapping 10 day period. The Crash of 1987 is still at the top of the charts on this one.
Both charts above were made in early October 2008. Here's the latest snapshot of two widely used measures of volatility, the VIX and the VXO (click for updates). As you can see, both blew well past the post-1945 record as measured by Bespoke and are back to the wild levels of the 1930s.
Markets, despite being the results of millions of individual decisions, have personality. Sometimes they are the very picture of bourgeois respectability. At other times, like now, the alternating moods swings of euphoria and panic resemble the turbo-charged highs and suicidal lows of a crack addict. "Nothing better! I'm gonna die!" Such is the wonderful world of the American capital markets, circa 2008.
If you want to learn more about volatility, the go-to-guy is Bill Luby at Vix and More.
High Yield Bonds Over 20%
This New York Times graphic is updated daily for high-yield bonds as well as other measures of credit stress.
This is bad news for businesses dependent on access to the credit markets, some of which face impossible rates above 20 percent to borrow anything. It’s also bearish for stocks, because bondholders get paid off before stockholders in a liquidation.
This is bad news for businesses dependent on access to the credit markets, some of which face impossible rates above 20 percent to borrow anything. It’s also bearish for stocks, because bondholders get paid off before stockholders in a liquidation.
High Yield Credit Spreads Top Levels of 2003
This chart from Bespoke Investment Group shows the “spread” or difference in yields between two classes of bonds: high yield or "junk" bonds and comparable Treasuries issued by the U.S. government. High yield bonds do well in times of economic expansion, as investors anticipate the great returns from the scenarios sketched in prospectuses. They do poorly in times of contraction, as the yields are driven higher (and the price lower) by fears of bankruptcy. The snapshot above was taken by Bespoke on October 2, 2008.The chart below (click for updates) measures the same thing as the chart above, but does so by taking the ratio between two exchange traded funds (HYG & TLT) that are proxies for high yield bonds and comparable long-term Treasuries. The panic in the week of October 6-10 drove the ratio down more than 30 percent from mid-summer 2008. "The corporate bond market," wrote one specialist on October 21, "is a broken shattered vessel and a shoddy reminder of its once mighty and powerful self."
AAA Corporate Bonds: Compared To What?
While we're on the subject, there's two other relationships to monitor.
One is the ratio of investment grade corporate bonds, rated AAA, with US Treasury bonds. That ratio has been going down, in a "flight to safety."
The other is the relationship between investment grade corporate bonds and high yield corporate bonds. That ratio has been going up, also in a "flight to safety." (click for updates).
Remember: these are not just squiggles on a chart. They have profound implications for the health of businesses and for future levels of unemployment.
One is the ratio of investment grade corporate bonds, rated AAA, with US Treasury bonds. That ratio has been going down, in a "flight to safety."
The other is the relationship between investment grade corporate bonds and high yield corporate bonds. That ratio has been going up, also in a "flight to safety." (click for updates).
Remember: these are not just squiggles on a chart. They have profound implications for the health of businesses and for future levels of unemployment.
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