Market Outlook: Ignorance or Insight?

There is no doubt that U.S. banks and more importantly, non-banks, have long been pursuing high risk practices in their approach to not only subprime, but also prime lending in the mortgage space. Loan structures that include low doc, no doc, I/O, low LTV, no down payment, etc. became rampant, particularly in more recent years leading up to the precipitous rise of interest rates and the onset of the “subprime crisis”. These were coupled with increased household debt and some of the same mortgage lenders also providing home equity lines and loans which further exacerbated the consolidated LTV (CLTV) of borrowers to levels never before seen in banking.

All of these have been a result of bad practices followed by worse practices. And there is no doubt that, predictably, a proportion of these portfolios (both prime and subprime) have and will go bad, and it is likely that this will be a higher number than we have normally associated with long run default rates of old.

HOWEVER, it is also true that up until the markets began to say “basta” and started a systematic devaluation of mortgage related players of all kind, relatively little of these bad practices were showing up in underlying mortgage portfolios through increased default rates or even a migration toward noticeably higher risk ratings. Many of the relatively cleaner lenders (both banks and non-banks) had long pulled out of I/Os, no doc, no down and many of the other more flagrant practices and had returned to more traditional structures and many of others would argue that they were never there to begin with.

Much of the market behavior has been targeted at anything with the word “mortgage” in the title, to the point where a growing number of very high quality funds and other players, all carrying pristine books, have been taken out, in some cases aggressively, by market devaluation, margin calls, and near predatory behavior on the part of certain notable investment banks. All of this has added fuel to the fire of market perception and generated rampant fear in many sectors. This, in turn, has led to a dive in the valuation of anything at all that is associated with mortgage (not just in equity prices) and has resulted in CDOs/SIVs/CMOs, etc. trading at distressed debt rates.

Once again, some of these instruments will no doubt have some portion of their underlying portfolios represented by the very bad practices mentioned above, but not all them and not all of their sub-portfolios. In fact, the percentage statistically would be less than 2.5% and less than that would actually default or become impaired. Many of the banks reporting significant capital constraints, write-downs, and negative earnings announcements are, in fact, riddled with these instruments, yet most are reporting that the overwhelming majority of these instruments are still performing, even today.

So, what has happened? Is it accurate to suggest that a pocketed group of players that have engaged in some very stupid lending practices have turned the tide for an entire industry? For these players, they certainly deserve what they get, as they were in the business of “high risk” and should have ensured adequate compensation, at least during good times. If they didn’t, then they deserve to go down. Likewise, markets should expect some of this and factor it into their analysis and pricing.

It is also true that a number of institutions have been overly concentrated in structured mortgage backed instruments, and a few have allowed their dependence on capital markets and the ability to securitize for funding and capital purposes to become so extreme as to run up loan to deposit ratios to an absurd extent (e.g. Northern Rock).

However, markets have potentially gotten it wrong as well. Not all of it is a disaster and not every one of these institutions, in fact, proportionally few, have been as flagrant as we have been lead to believe. Have the markets over-stated the case? Are the markets now causing a minor form of hysteria? Many companies have been undeservedly forced out of business, shareholders have lost billions, and housing valuations have plummeted along with demand and, in turn, so has the building construction industry. This, in turn, has further impacted jobless and default rates. Where does it stop? How do we keep markets in check?

Many of the recent responses revolve around broadening the role of the regulator and looking more closely at the mortgage industry. The value of this can be debated, but these responses only address the immediate problem at hand. Is there a rationale for better qualifications for market participation? Is it possible that, similar to the cases we saw emerge seven or more years ago post tech bubble, some institutions have engineered at least some of these outcomes? Is it ignorance or is it conspiracy?

My view: markets over-reacted against legitimate concerns over bad practices in some sub-sectors of the mortgage industry. Effectively, the pendulum swung from euphoria to nausea, driving what was likely an over-valuation of some players to a wild underestimation across the board. Markets ceased to distinguish the difference and panicked. There is no conspiracy theory, but as in every market event, someone is likely to emerge a winner: a few smart players have managed to turn strategy rapidly and take advantage of an opportunity. Both of these behaviors have served to deepen and prolong what might have otherwise been a more contained event. Market perception has managed to generate a self-fulfilling prophecy which has yet to fully play out.

14 Responses to "Market Outlook: Ignorance or Insight?"

  1. London Banker   May 16, 2008 at 10:14 am

    Why does it have be ingorance or insight, ignorance or conspiracy? It is easy to conceive of a system where some dominant players have insight, form a conspiracy, and take advantage of the ignorance of the other players in the system to unfairly game the system to their advantage. Where some players have a dominant role in determining regulatory policy, monetary policy and legislation, then the idea of a conspiracy of self-reinforcing elites is both practical and very tempting. They could, for example, promote subsidies, tax exemptions and liquidity facilities that promote the mortgage industry at the expense of productive investments in other economic (and much more productive) activity. They could, for example, promote subsidies, bankruptcy reforms and liquidity facilities to underpin widespread use of revolving credit like credit cards, discouraging responsible consumer savings and investment choices. They could, for example, promote tax exemptions and mandatory statutory contributions to pension schemes and insurance schemes that they will get to manage for high fee income and to absorb any portfolio losses that they want to hide from their own trading books.Cock-up or conspiracy, the system doesn’t look good, and it’s been going wrong for so long it is going to be very difficult to unknit without long term systemic damage.

  2. DR   May 16, 2008 at 11:19 am

    @ AC and LB;Agreed the system doesn’t look good. And the long term systemic damage that ocurs, the professor has alluded to there being a recoupling. But given that there seems to be transformation of a bigger bang event into a more protracted problem, does this mean a systemic correction is limited to western central banks/markets and the emerging markets can safely go their way as their population is not contained with the housing malaise and political shenanigans in the market?

  3. Annetta Cortez   May 16, 2008 at 5:55 pm

    LB-Although I’m a gal who intellectually enjoys a good conspiracy theory, having been in many of these institutions (both banks and policy makers), it’s hard to imagine that any of them would be good enough to pull it off – both individually or collectively. Some of this takes a fair amount of foresight if nothing else and most don’t seem to be able to manage to handle the development of a strategic plan that has a practical trajectory of more than about 3-6 months, they frequently fall afoul of their own internal political machinations,and operatoinally many can barely proverbially tie their own shoes. The idea of a group of players being collectively good enough to lay out and execute what would have to be a long term plan, seems almost ludicrous when you consider the competencies – I see this every day.Having said that, opportunism is rampant and seems to be pushing to the level of full on economic and systemic irresponsibility. This begs the question to what degree there should be a "watchdog" of sorts in the system. It strikes me as an interesting idea, but something that would be practically hard to pull off (I can see the "czar of stupid market behavior").

  4. Annetta Cortez   May 16, 2008 at 6:16 pm

    DR-Systemic correction would not be limited to Western banking systems. I live and work globally and spend quite a time in AustralAsia. In Asia, we’re seeing market fundamentals that make the US market look benign and rational. Non-performing assets are averaging across Asia at roughly 6.5%. China alone is posting over 24% and growing. Banks are provisioned at an average of 65% (normally banks at least match NPLs on provision) and China is averaging about 35% provisions (possibly much less on unofficial estimates). The share markets are exhibiting behavior akin to the tech bubble – growth in the past few years has been extreme, but on strictly new volume with lousy underlying fundamentals (in fact blue chips have been consistently falling against increasing index ). To top it off, real wages have been consistently declining since the Asian crisis and inflation is through the roof. The lower income end of society is starting to become stressed to pay for basic food supplies. Even countries like Australia, fundamentally much more stable, are seeing the stress on inflation, wages and a 17 year low in productivity with NPLs increasing steadily, and agressively rising interest rates. And there, the mortgage system is largely based on fully floating rate products with many of the same credit woes of US consumers. Many of these sorts of statistics make our problems in the US look pretty benign comparatively. Although many of the overseas banks are less fully coupled to the US, they are in such poor shape that any good healthy systemic sneeze could bring it all down. The issue that we see, however, is that it is fairly likely that places like Asia could weather the US Subprime situation quite easily: banks are far less dependent on capital markets for funding. Floats are low, only a couple of countries are active in bond markets for funding, securitization is fairly undeveloped, etc. There is some unreasonable holding of US CDOs and SIVs but the system has poor transparency and on a negotiated agreement with regulators, will not likely take mark-to-market losses in most countries. We’re seeing a sitatuion where, particularly in China, the financial system is already technically insolvent and being propped up by Central Banks.Nevertheless, the fact that growth has been high and the direct effect of Subprime is low, may result in banks and regulators reaching a false sense of confidence, particularly agains the back-drop of much congratulations from pulling out of the Asian Crisis.But any signs of instability, particularly from China, which is driving much of the pan-regional growth, could result in a very unpleasant fall.

  5. 2cents   May 16, 2008 at 10:32 pm

    @ Annetta Cortez Here in America I say ‘hasta la vista’ to you!You act like this is an issue at the margin. Get real!LB please pick better authors and critique thier posts before they go up. I’m all for opposing opinions, but this wingnut is living under a rock. This comes off as being the way Annetta ‘feels’. There are enough posters on this sight that ‘feel’ every post. What we need are authors who have vision and make a case!

  6. 2cents   May 16, 2008 at 10:34 pm

    That’s ‘site’ not ‘sight’ above.

  7. Anonymous   May 17, 2008 at 8:20 am

    Annetta said:Although I’m a gal who intellectually enjoys a good conspiracy theory, having been in many of these institutions (both banks and policy makers), it’s hard to imagine that any of them would be good enough to pull it off – both individually or collectively.Dear Annetta,I’m afraid your statement shows that you have not been deep enough in these institutions or closer to the trenches during market warfare.It’s not a matter of being "good enough" to pull it off but:a) Being amoral enoughANDb) Being sure the regulators are on your side (i.e. turning a blind eye to your doings).Market manipulation is not rocket science. It’s 90% brute force and right in the open for everyone to see – if they know what to look for and how to interpret it.

  8. Annetta Cortez   May 17, 2008 at 8:31 am

    @2CentsNot an issue at the margin- quite the contrary. But one that might have been better managed at the very least. Irresponsible lendor practices being supported by irresponsible regulatory response and followed up by irresponsible market analysis and so on and so on.

  9. Annetta Cortez   May 17, 2008 at 8:39 am

    @Anonymous-I agree completely with you. But quite the contrary on the experience front. I’ve been in the trenches and toe to toe with regulators. I’ve seen the deal making, bullying and fast talking. But this is more like rampant opportunism rather than a well-constructed conspiracy theory.

  10. DR   May 17, 2008 at 2:18 pm

    AC,thanks for the assessment. Blogs like these can become meaningless when the cause and effect on activity and participants are treated as two separate things.I’m absoloutely interested in how WE can navigate these markets as investors. The scenario you layed out is the death trap for those who feel that I better jump on the equity/housing/other bandwagon before it’s too late. That the two big to fail hypothesis is real.How about the other hypothesis, the bigger they are, the harder they fall. So who is smart enough and fast enough to get out before the giant falls? Who in housing did it? Who in tech did it? I would suggest only the ones who took a good look at fundamentals…

  11. eparisi   May 18, 2008 at 11:34 am

    http://www.federalreserveeducation.org/fed101/structure/BOD/BOD.htm"Each Reserve Bank has a board of directors representing the private sector, which selects the Bank’s officers and oversees the general operations of the Bank. All Reserve Bank directors serve three-year terms. The 9 members of the board of directors are familiar with the district’s economic and credit conditions and broadly represent both the Bank’s stockholders and the public served by the Bank. Each board is divided into three classes of three persons each. * Class A directors represent commercial banks that are members of the Federal Reserve System, since these banks are the Reserve Bank stockholders. * Class B directors represent the public and are drawn from diverse sectors, including agriculture, business and labor. They may not be officers, directors or employees of any bank. Class A and B directors of each Reserve Bank are elected by the member banks in that Fed’s district. * The 3 Class C directors also represent the public and cannot be officers, directors or employees of any bank."

  12. 2cents   May 18, 2008 at 8:54 pm

    @ Annetta Cortez on 2008-05-17 08:31:26 Not an issue at the margin- quite the contrary. But one that might have been better managed at the very least. Irresponsible lendor practices being supported by irresponsible regulatory response and followed up by irresponsible market analysis and so on and so on. To Qoute You "Once again, some of these instruments will no doubt have some portion of their underlying portfolios represented by the very bad practices mentioned above, but not all them and not all of their sub-portfolios. In fact, the percentage statistically would be less than 2.5% and less than that would actually default or become impaired."And another quote "However, markets have potentially gotten it wrong as well. Not all of it is a disaster and not every one of these institutions, in fact, proportionally few, have been as flagrant as we have been lead to believe. Have the markets over-stated the case? Are the markets now causing a minor form of hysteria?"Oh Yeh, I misinerpreted your statements as you arguing that it was "at the margin"! You my fair lady are a nimcompoop!

  13. TraderJack   May 18, 2008 at 9:32 pm

    Here! Here!Annetta- A good overview of the state of affairs and forces shaping them. Market perception has driven much of this issue and has yet to unfold. If anyone is unsure of the degree of this, check current market rates of mortgage-backed facilities vs. worse-case/stressed default rates in the mortgage sector. They don’t add up!

  14. dc   May 23, 2008 at 9:38 am

    Anonymous, I’m with you.Annette, 1. Pleas prouf your posts… :)2. "Although I’m a gal …." How about woman?In my opinion, neither of the above underscore your professionalism.3. "But this is more like rampant opportunism rather than a well-constructed conspiracy theory." What if the "..rampant opportunism…" is a function of "….a well-constructed conspiracy theory." ?eparisi, I did not know this. Thanks for the clarifying the distinctions.DC:Collectively speaking, isn’t one persons’ problem anothers’ solution?ANYONE, please tell me exactly who IS benefiting from this mess?(who, how and why..)