The eye of the storm

In-Equitable treatment

Victims of Equitable Life are to be paid off by the taxpayer, says the FT.

Equitable Life ran a with-profits fund, a form of collective investment that only goes up (as long as you maintain it to the end of the agreed term). Once awarded, bonuses on with-profits funds cannot be taken away. EL's undoing was that, like some other companies, they dragged in extra pension business a long time ago on the selling point of guaranteeing (in their case) a 12% annuity rate when the plans matured. That is, for every £100 in the fund, the life time income would be £12 per year.

When we moved from a high inflation/high interest environment to low/low, this promise became a ticking time bomb. When annuity rates generally have dropped to 6% or less, you need to double the fund to create the same income. So since there wasn't enough in the kitty, EL had either to renege on the guaranteed annuity rate (GAR), or take away much of the bonuses already awarded. I believe they tried both approaches and the courts wouldn't let them.

This GAR depth-charge was well known, or should have been known, to actuaries. The IFA network I was with in the 90s used to have a shortlist of approved companies (including non-commission payers) for each product, and at some point EL quietly dropped off the list. If outsiders could see the disaster looming, we have to assume the technical advisers on the inside knew even better what would happen. Yet EL carried on awarding bonuses to investors as though nothing was wrong.

Now, it seems compensation is to be paid because industry regulators failed to spot the coming crisis and step in. It's as though houseowners could sue the police for not stopping Bill the Burglar. Perhaps it helps EL investors' case that so many of them happen to be lawyers and journalists?

However, what is sauce for the goose is sauce for the gander. The same arguments can be applied to victims of the mortgage mis-selling of the past few years. For Equitable Life, read banks; for investors, read borrowers. And in both cases, it's the same regulator now.

Compensation, please.

Roubini: bailing out government mortgage lenders could downgrade the USA's national credit rating

If we fiscalize all of these losses the U.S. may fast lose its AAA sovereign debt rating and eventually end up like an insolvent banana republic.

Nouriel Roubini, quoted in Mish's.

Forgive us our debts, Part 2

A very stimulating response from "Caronte" to the earlier post on debt reduction, so I've taken the liberty to bring the argument out front here.

Caronte, you say:

Suppose it is believed with absolute certainty that every 50 years, say every year divisible by 50, all debts are forgiven. There would follow a bunching of loan demand as the forgiveness date nears, while willing lenders would simultaneously vanish. The market would no longer match credit demand and supply, total welfare would suffer. Debt forgiveness would only avoid this problem if it was done by stealth, unpredictably, once and for all and never again. Like forgiveness of tax evasion or illegal buildings. Difficult to persuade debtors, (or builders, or taxpayers), that forgiveness would not occur again. Lots of people would be encouraged to borrow beyond what they can afford (or evade tax) – the moral hazard implication. Unsustainable indebtedness would multiply rather than disappear. Moreover, a defaulting borrower does not need forgiveness if she genuinely cannot pay: can’t pay, won’t pay, period. If the defaulting borrower has some residual wealth, though less than the outstanding loan, who is to deprive the creditor of that? What legal or moral right would support state action without creditor compensation?

Would “debt cancellation (or rather, reduction) … be a suitable punishment for the principal offender”? True: “the relationship between mortgage lender and borrower is unequal. You have to live somewhere, and if you don't buy, you have to rent - and rents will tend to reflect the purchase price of houses.” No more than the relationship between employer and worker. There are various way to reduce this inequality, workers can form Trades Unions and cooperatives, and borrowers can found building societies – until New Labour wickedly de-mutualised i.e. privatised this form of social property which was not theirs to privatise. But the main reduction of the inequality comes from competition among lenders (and among employers).

“By adjusting the ratio of deposits to loans as it suits them, lenders can multiply the money supply”. True, there is a credit multiplier at work when banks re-lend their deposits and get some new deposits as a result. If they were prevented from re-lending – by law or by contract – they would act solely as custodians (as in the early days of gold-money) and would charge depositors for the service instead of paying interest. And any act of individual saving would instantly reduce total demand by the same amount and cause unemployment. Besides, the ratio of deposits to loans is regulated by law and is variable at will only when it is higher than a prudential limit. And banks face the consequences of their bad loans, they can go bankrupt and their shareholders can lose all their capital. That’s punishment enough. As long as they are competitive, there is not much of a reason to “punish” them by forcing them to remit those bad loans that still have a residual market value.

“Rather than prop up the worst of the lenders, let them go down. Why should the taxpayer assume the burden?” Absolutely right. “Pay off the depositors” – if the bank can, or if there is a state guarantee. But why “shrink the lending book” by debt remission? If mistakes are always to be automatically corrected ex-post when they are revealed as such, the market disappears and with it all the conceivable advantages that it brings.

An Australian economist whose name now escapes me once wrote an article mocking the theory of general economic equilibrium – with its complete system of futures markets – by imagining a system of “past” markets in which economic agents could undo their past transactions that with the benefit of hindsight turned out to be a mistake. Just imagine. Debt remission would have some of the same effects.

I say:

Caronte, welcome, and many thanks for the length and thoughtfulness of your response. I don't pretend to have your economic expertise, but I still think there's a debate to be had. I'll try to tackle some of your points, not necessarily in strict order.

I suppose that in ancient Israel, the economy was not so monetised as today, so the advent of the year of Jubilee may not have been so disruptive as it would today. I don't really advocate a periodic debt cancellation - though I'm beginning to wonder about the necessity of charging interest. (Isn't it the case that some Swiss banks do in fact charge you for looking after your money securely, instead of making investments with it or lending it out to others?)

Competition between lenders may help keep down interest rates, but it's the ballooning of asset prices - and the consequent increase in the size of mortgage required - that causes the damage. So many are now locked into monster mortgages that a significant rise in interest rates - which otherwise might be appropriate for tackling inflation - is politically very unfeasible.

I argue that the price of houses is pretty much beyond the buyer's control, except that there's a point where a purchase is either not affordable (we seem to have reached that stage) or, as with subprime, fudged at the outset with disastrous consequences later. So I suggest the expansion of credit (for which, as you say, regulators also share responsibility), and the terms set by fee-hungry lenders and intermediaries, are more to blame than the family that wants a roof over its head it can call its own. Finance for cars and consumer goods is something else; a house is a necessity, and surely, owning one is not an unreasonable aspiration.

Banks should be, but are not being made to face the consequences - look how governments are propping-up Northern Rock and Bear Stearns.

Debt reduction does not seem unreasonable to me. If a life insurance company fails, the book of life business can be passed on to another provider, who is only required to underwrite 90% of the outstanding life cover. So why not for lenders who (through greed and stupidity) have gotten their sums wrong? A 10% reduction in the capital only represents a couple of years' interest. Better a borrower who repays a reasonable proportion of the loan, plus interest, than simply mail back the keys and leave the bank with illiquid stock it doesn't know how to manage.

This is not a problem limited to a single bank -and anyway, there are far fewer these days, and they are much larger, so one failure could really rock the boat. At worst, we could now be facing the prospect of mass bankruptcy, the crash of the credit system and general economic carnage. It's worth coming up with some fudge to keep borrowers and lenders going.

Here in the UK, you can enter an agreement with creditors and as long as you keep up the scheduled payments, interest charging stops altogether. Maybe that would be another way forward - the monthly repayment would be lower and the borrower would see his equity in the house increase over time.

We've been watching enslavement by money-owners who have been licensed to print almost unlimited amounts of their own money, but the poor man only feels it going past and can save none, so remains in debt-bondage. Better any reasonable rearrangement, than "I owe my soul to the company store".

Forgive us our debts

In one version of the Lord's Prayer, the word "debts" replaces "trespasses", and this is in keeping with the etymology of "redemption". The ancient Jewish law forbade perpetual debt-slavery for fellow-believers, and even provided for ceremonial debt forgiveness every 50 years (which, I imagine, had a feedback effect on the terms and length of loan agreements).

"Hatfield Girl" gives a very vivid picture of our slow slide into dingy, shabby poverty, and it has to be every sane person's earnest wish that we (or our fellow citizens) don't return to the conditions so many suffered before the Second World War. Yet what is causing all this but the heavy chains of debt?

A disclaimer: I often feel that I not only know nothing, but never shall know anything, despite much effort. Then I see how the world is going, and wonder who knows better.

Having said that, I'm trying to work out why, as Karl Denninger says, we don't make the banks eat some of the debt they laid on us. In the comments to the Hatfield Girl piece linked above, "Caronte" refers to "moral hazard", a point I entirely accept. But I say that debt cancellation (or rather, reduction) would be a suitable punishment for the principal offender.

In our society, the relationship between mortgage lender and borrower is unequal. You have to live somewhere, and if you don't buy, you have to rent - and rents will tend to reflect the purchase price of houses.

So what determines the price of houses? Supply and demand. And a major element of demand is how much money is available. By adjusting the ratio of deposits to loans as it suits them, lenders can multiply the money supply, as everyone knows (I say everyone, but actually I don't think the public is fully aware of the simplicity and enormity of this scam). Since 2000 or so, the money in the economy doubled, and so, un-oddly I think, did the price of houses.

The lender can decide how much to lend into the market generally, and consequently influence it; the buyer cannot decide, on an individual basis, to halve the value of the type of house he wants in the area where he needs to live.

So by what right should lenders inflate asset prices, fix on them loans of money they created virtually ex nihilo, then deflate asset prices by reducing lending in difficult times, and expect the borrower to bear the full weight of the consequences?

The borrower may have colluded with the lender to take on an unsustainable debt (or one that exposed the borrower to excessive deflation risk), but for reasons already given I suggest it was a shotgun marriage (or a mass marriage, like those Moonie wedding rallies) with the lender handling the Purdey. For subprime borrowers, I think it's fair to argue that the class of people involved means that the lenders had far better knowledge of the implications, and so are far more culpable.

Rather than prop up the worst of the lenders, let them go down. Why should the taxpayer assume the burden? Pay off the depositors, but shrink the lending book - which is mostly funny money, less substantial in its origins than candy floss - a drop of ink on 80-gram paper.

To quote the inscription on the statue of Justice above the Central Criminal Court, "Defend the children of the poor and punish the wrongdoer." The trespasses of the mighty are less to be forgiven.

Property slump or stall?

Karl Denninger says house prices over the last 100 years have averaged three times income. What's the implication for us?

This BBC survey says the average semi (a standard unit of housing, one would think) is "worth" slightly over £200,000; official statistics put household income at £33,492. So houses cost around six times earnings.

That suggests a 50% drop is due. But as Keynes observed with wages, house prices tend to be "sticky downward": no-one is in a hurry to realize a big loss on their home equity. Death, divorce and redundancy may force some sales; others may choose to wait, or go for house swaps.

Or wages could double. Up till recently, it was a standard assumption that "inflation" would run at 2.5% p.a. and wage increases 2% above that. Using the "Rule of 72", it would take 16 years of 4.5% wage increases to double nominal incomes.

Whether wages will always rise in real terms, is another matter. One of the effects of globalization is to hold down wages in the developed countries; and food and energy costs look as though they will continue to rise as the rest of the world gets richer and more populous.

From soup to nuts

Steve Moyer gives a pretty clear (occasionally a bit aerated) potted history of the woeful train of events, over the ten years from the start of the technology stock boom to the popping (and it's only just started) of the real estate bubble.

Nobody had to invest in tech stocks, but we all have to live somewhere. A bubble in housing is really pernicious, because it has implications for almost everyone.

Low interest rates inflated property prices, which led to much larger mortgages. Deflating valuations by raising interest rates would trap many mortgage-holders who have taken on big loans and kept up a good credit history so far.

Therefore, unless the government is willing to deal with the political pain of accelerated mortage defaults, interest rates must now stay low-ish for a long time. So I guess that credit risk will be adjusted not by price, but by access: it will simply get harder to find a willing lender. If there is less lending, then that (it seems to me) is deflationary.

I don't believe that the burden of the monster mortgage will be reduced by rapid general inflation of both wages and prices as in the 70s and 80s. Increased world demand for food and energy will inflate prices, but globalisation means that for many - especially the poorer sort - wages won't keep up. The cost of housing will be a generation-long millstone around the neck.

Inflating the currency won't help. It will reduce the wealth of savers, but if we are importing not only luxuries but (increasingly) necessities, inflated wages will be gobbled up by inflated import prices.

Some may argue that currency debasement will make our exports more competitive. But for a long time now, manufacturing industry has been disappearing like snow in midsummer. Even if our export prices should become more competitive because of foreign exchange rates, domestic productive capacity has shrivelled: whole factories and shipyards have gone abroad, and the related human resources have withered, too. You can't reconstruct the proletariat and their workplaces overnight. Gone are the days when the Midlands engineering worker tinkered with metal in his garden shed, showing his son how to use the tools. Half a mile from where I live, one of the big engineering plants set up by the Birmingham-based Lucas family was taken over first by the Italian Magneti Marelli, then by the Japanese super-corp Denso, and now it's been stripped of its machines and will be demolished to make way for... housing. Goodness know how the mortgages on them will be paid.

I think Karl Denninger is right: the banks must be made to eat some of the debt they fed us. Either they will be ruined, or we shall be.

Eat what you cooked

Karl Denninger comments on the proposals to make banks write down some outstanding capital on loans, to secure what's left of the banking system. Painful, but it might save the day.

I wouldn't say it's impossible. America has more resilience and capacity to renew than its envious enemies wish to believe.

Good luck.

Subprime hitting GSEs

Karl Denninger comments trenchantly on a new scheme by "Fannie Mae", the government-sponsored mortgage lender: "Homesaver Advance" takes the borrower's missed mortgage payments and puts them into an unsecured loan, thus "healing" the credit history so that home lending can continue as if (as if!) everything were normal. Denninger sees this as a signal to "short" Fannie Mae.

But over a period, Denninger has moved on from trying to exploit such market weaknesses, to urging his fellow citizens to protest about the corruption of the financial system. His tone is now getting darker - like Jeffrey Nyquist, he's beginning to worry about international relations, for example the way that China's population pressure may threaten Russia's land. Lhasa 1950, Khabarovsk and Irkutsk when?

The Fed and King Canute

Michael Panzner directs us to John Hussman, who explains that the Federal Reserve's power to manage the financial system is very limited - the funds it provides are dwarfed by the amount out in the economy.

... the problem with the U.S. financial system ... is not liquidity, but the solvency of mortgage loans and securitized debt. The Fed's actions are not likely to have material impact on this.

This, plus Larry Lindsey's comments noted in my previous post, adds weight to Karl Denninger's continuing theme of inevitable deflation.

Lenders should tremble

"Genesis" at Market Ticker explains that US lenders who colluded in fraudulent mortgage applications can be forced to have the properties back at their original valuation.

The mortgage conundrum

Much of the nation's wealth seems to be tied up in our houses, which don't appear to be very productive from an economic standpoint. There is a kind of circular logic:

1. Houses cost a lot, so you have to borrow a great deal of money to buy a house.

2. Houses cost a lot, because you can borrow a great deal of money to buy a house.

Having regard for the wider consequences of your proposals, what is the optimum solution?

The outlook from Financial Sense

Some voices and topics from Financial Sense, 25 August:

inflation, deflation, gold, cash...

Jim Puplava: ...I've had Bob Prechter on this program and Bob is a deflationist and Bob believes that we get deflation first and then hyperinflation where I guess my views are we get hyperinflation and then what follows will be deflation. And that's the way it has unfolded with great debtor nations. And I think history will repeat itself here with the US. There is too much debt here and it has to be inflated away...

...I really believe that the full force of these storms aren't going to hit until somewhere between 2009 and 2010 when this really comes home to roost. And all of these debt problems, the problems that we have with energy today, availability, peak oil, the geopolitical problems in the Middle East – I do not expect the next decade to be a pleasant one, John. I wish I could say otherwise because as a father with three children, one to get married shortly and looking forward to grandchildren, you know, this is something that you don't like to think about...

credit bubble, credit crunch, commodities, East delinking from West...

Doug Noland: ...the economy is much more vulnerable than many believe because of the credit that was going to the upper end; and I think the upper end mortgage area is where we had the greatest excesses.

So I think when all is said and done, subprime losses are going to be small compared to the losses we see in jumbo and Alt-A, and especially, unfortunately out in California...

...there’s desperation out there to find buyers for mortgages... Washington generally doesn’t understand the risk of Fannie and Freddie [US government-sponsored entities - "GSEs" - that offer mortgages], so of course they would think it’s their role to step in and provide the liquidity.

But... their total exposure is over 4 trillion dollars now. And this is a huge problem, and I fully expect down the road these institutions to be nationalized. And I think the US taxpayer is going to pay a huge bill for this... To be honest, I don’t mind the GSEs if they want to play a role in affordable housing; if they wanted to try to rectify some of the problems at the lower end because of the lack of the availability of credit in subprime. But to think that the GSEs should start doing jumbo mortgages, to try to be the buyer of last resort for California mortgages, my God, it’s hard to believe that makes sense to anyone because that’s just a potential disaster. It’s also reminiscent of the S&L – the Savings and Loan problem that, you know, was a several billion dollar problem during the 80s that they allowed to grow to several hundred billion by the early 90s. And definitely, the tab of the GSEs is growing rapidly right now...

...even if the central banks add a trillion dollars of liquidity to help out this deleveraging we still have this issue of how are we going to generate the trillions of additional credit going forward to keep incomes levitated, to keep corporation earnings levitated, to keep asset prices levitated, to keep the global economy chugging along...

...The global economy may be something of a different story because we have credit bubbles all over the world. Like the Chinese bubble right now is pretty much oblivious to what’s going on in the US and in Europe. You can see a scenario where, you know, you have serious credit breakdown but let’s say Chinese demand keeps energy and resource prices higher than one would expect. So I’m going to be watching this very carefully because we’re going to see some very unusual dynamics as far as liquidity and inflation effects between different asset classes and different types of price levels throughout the economy.

And another thing...

Surely, people who can't afford their mortgages don't have big investments. So aside from default losses impacting on portfolios, I don't see a great need to sell one's holdings (or a wonderful opportunity to buy).

But when the market is worried, private investors tend to get rid of their stocks, which as they drop in price are snapped up by the patient, crocodile professionals. Watch for data on the changing proportion between private and institutional holdings - please let me know when you spot it.

Peter Schiff: US Treasury less creditworthy

Peter Schiff in FXStreet today mounts a vigorous defence of his record of warning us that subprime problems would spill over into other credit areas. The market appears to be waking up to this, but he says there's worse to come:

A much larger disaster looms for holders of U.S. dollar denominated assets in general. It will not be long before our foreign creditors realize that Uncle Sam is the biggest subprime borrower of them all and will similarly mark down the value of its debts as well.

Once again, why has Britain recently become the third-largest holder of American debt? Our exposure is now 3 times higher than about a year ago.

Desperately holding down gold

Jim Willie of the Hat Trick Letter thinks that bank selloffs of gold are to make dodgy bonds look better than they are. If the mortgage bonds unravel, there's a lot of fast talking to be done by banks and brokers.

More on US housing woes

An informative piece in Dr Housing Bubble on the various factors that are turning the housing market upside down.

If I read the first graph rightly, there's a peak in the numbers of temporarily-fixed US mortgages that are due to come back onto the current variable rate in November this year, which suggests we may have a difficult autumn ahead. Further cutbacks in discretionary spending, presumably.