Debt, Credit, Obligations and Trust
It feels like we are moving through a watershed moment in both the U.S. and global financial markets. When the mortgage securities market collapses as though it was the tulip bulb market centuries ago in Holland it is truly time to take pause and look at what has been allowed to occur. Mortgages, secured by real estate, have long been considered as a secure type of investment, unlike say junk bonds. Now the marketplace is saying that they cannot value them so no one is either buying them or allowing them to be used as loan collateral. Wow!
In the new global electronic trading marketplace, mentioned in the last post, there has been a vast amount of new investment vehicles created in the past 20 years. These new investment products, ever more sophisticated and varied, gave investors new ways to hedge portfolios, take on or alleviate risk and accelerated the electronic flow of capital around the world. They also were created, in part, by investment banks to create new sources of fee revenue. This was the beginning of the problem as it led to investment instruments to become disconnected from the underlying asset. Once a mortgage was granted to a home buyer, that same mortgage was pooled into a mortgage backed security and sold to a buyer, often in a matter of weeks or months. There was no longer any connection between the home owner who was paying down the mortgage and the holder of the mortgage. No relationship existed. As we all know, having a relationship can stabilize any situation.
I remember buying my first home and being forced to not only go through a detailed and rigorous application process to obtain the mortgage, but that I also mailed my mortgage passbook into the S&L every month with my payment. Days later I received it back in the mail with the latest payment credited against interest and the reduction in principal. I was one of those risky loans as I had put only ten percent down. During the entire four years I owned that home I did this month in and month out. This type of relationship has ceased to exist. The days of the Bailey S&L from â€œItsâ€™ a Wonderful Lifeâ€ have been gone for a long time.
In January, I predicted that the residential real estate marketplace would not recover this year. Not only is that still the case, but the current market meltdown in mortgage backed securities has extended the length of the downturn significantly. It will not be until the second half of 2008, at the earliest, that the national real estate marketplace has a chance to make a consolidated move upward again.
Whenever I look ahead to the 2008 elections and the 4-5 years beyond them, one of the most troubling areas is debt. It is at record levels and increasing. Consumer debt to maintain lifestyles, corporate borrowing, mortgage debt and of course the $50+ trillion of obligations the U.S. government is carrying all seem to continue to spiral upwards as though they are taking on a life of their own. The issue here is that all of this is getting disconnected from economic fundamentals. There is no historical precedent. Investment has become speculation, across the board. People buy homes with no money down and no payment of principal and with a promise to pay higher rates. Companies borrow at historically low rates betting on a significant increase in revenues. The worst culprit of course is the U.S government, as no one in it can tell you how the funds they are borrowing today will be paid back tomorrow.
The key here is that everyone is borrowing against a future event; housing prices always going up, sales increasing on plan, and of course the U.S. government elevating Alfred E. Neumann as their philosophical guru with his philosophy of â€œWhat? Me Worry?â€
Hedge funds, and the major investment banks that service them, are to some degree at fault in this current downturn as they have speculated on investment vehicles that are disconnected from underlying assets, used credit to leverage even further, and then when faced with illiquidity â€” how could they not see that coming â€” dumped equities to cover as best they could. During the course of the next several months, we are going to some hedge funds collapse; others sell their remaining holdings for a discount to other funds and a continuing crisis in the mortgage and mortgage security marketplaces. The stock market could in fact resume itsâ€™ path to new records, but that will not solve these problems
The real question, and the one that has the most dangerous possible ramifications is to what degree has trust been evaporated, and if so for how long? We have all, to some degree felt the pain of being part of this market speculation. Speculation is not to be trusted in the near term. Will our credit markets, debt instruments and the great names in the investment community maintain our trust going forward? I hope so for all of us.
[For those of you that think some hedge funds are self serving, speculative entities, I urge you to read James Howard Kunstlerâ€™s blog, http://jameshowardkunstler.typepad.com/clusterfuck_nation/ as you will enjoy it immensely. He is a great writer, with a wonderful sense of humor and a view on the world always worth reading.]