US Sub-prime crisis was public policy gone badly wrong

From the Financial Times' ftalphaville blog of this morning:

Michael Cembalest has made a retraction. JPMorgan’s private banking chief investment officer has a new view on the roots of the US subprime debacle.
From a note sent last week:

Retractions: US earnings growth, the Euro, and the primary catalyst for the US housing crisis

Agencies played a larger role in the housing crisis than we first reported. In January 2009, I wrote that the housing crisis was mostly a consequence of the private sector. Why? US Agencies appeared to be responsible for only 20% of all subprime, Alt A and other mortgage exotica. However, over the last 2 years, analysts have dissected the housing crisis in greater detail. What emerges from new research is something quite different: government agencies now look to have guaranteed, originated or underwritten 60% of all “non-traditional” mortgages, which totaled $4.6 trillion in June 2008. What’s more, this research asserts that housing policies instituted in the early 1990s were explicitly designed to require US Agencies to make much riskier loans, with the ultimate goal of pushing private sector banks to adopt the same standards. To be sure, private sector banks and investors are responsible for taking the bait, and made terrible mistakes. Overall, what emerges is an object lesson in well-meaning public policy gone spectacularly wrong.

For [Edward] Pinto and [Peter] Wallison [authors of two recent reports on the subprime crisis] this quote from the Department of Housing and Urban Development in 2000 is a smoking gun of sorts, and lays out a blueprint for the housing crisis:
‘Because the GSEs have a funding advantage over other market participants, they have the ability to under price their competitors and increase their market share. This advantage, as has been the case in the prime market, could allow the GSEs to eventually play a significant role in the subprime market. As the GSEs become more comfortable with subprime lending, the line between what today is considered a subprime loan versus a prime loan will likely deteriorate, making expansion by the GSEs look more like an increase in the prime market. Since, as explained earlier in this chapter, one could define a prime loan as one that the GSEs will purchase, the difference between the prime and subprime markets will become less clear. This melding of markets could occur even if many of the underlying characteristics of subprime borrowers and the market’s (i.e., non-GSE participants) evaluation of the risks posed by these borrowers remain unchanged.’ (HUD Affordable Lending goals for Freddie Mac/Fannie Mae, Oct 2000).
The strategy worked, as shown in the chart: the Agencies took the lead in the 1990s and early 2000’s in both subprime and high [loan-to-value] (>=95%) loans, acquiring over $700 billion in non-traditional mortgages before private markets had even reached $100 billion. Then in 2002-2003, private sector banks took the bait and jumped in with both feet. According to Wallison, the distortion of the housing bubble from 1997 onward obscured what would otherwise have been rising delinquencies and losses. As a result, when investors, banks and rating agencies finally got involved in a substantial way, they ended up looking at understated default statistics on subprime, Alt A and high LTV borrowers.

… The Wallison/Pinto research appears to be a well-reasoned addition to the body of work dissecting the worst housing crisis in the post-war era. It is convincing enough to retract what we wrote in 2009. As regulators and politicians consider actions designed to stabilize the financial system and the housing/mortgage markets, reflection on the role that policy played in the collapse would seem like a critical part of the process.

Links to Pinto and Wallison’s reports are here and here.
If you’re wondering why it took Cembalest and Co so long to figure this out after the housing collapse, the JPMorgan analyst blames nothing less than “creative reporting” that masked the agencies’ real subprime lending. Fannie Mae classified a mortgage as subprime only if the loan was originated by a lender specialising in subprime, or by the subprime units of the big banks. They didn’t use things like credit, or Fico, scores to report all subprime exposure, thus reducing its reported subprime loan count.
And if you’re thinking private sector banks and brokers still made much worse loans than the government agencies on a dollar-per-dollar basis, well, Cembalest has a response for you too:

… Wallison and Pinto are not trying to find out who made the worst loans. They’re trying to figure out why underwriting standards collapsed across the board; how policy objectives were designed to have private sector banks follow the Agencies off the cliff; and why Agency losses to taxpayers are estimated to be so large ($250-$350 billion). It’s a hollow victory for Agency supporters to claim that their version of Alt A and Subprime was not as bad as private sector ones: the Agencies had almost no capital to absorb losses in the first place, given what their mandate was. According to the Financial Crisis Inquiry Commission, “by the end of 2007, Fannie Mae and Freddie Mac combined leverage ratios, including loans they owned and guaranteed, stood at 75 to 1.” After factoring out tax-loss carry-forwards, Agency capital ratios were probably below 1% on over $5 trillion of aggressively underwritten exposure.

Ouch!

Manmohan working on his epitaph

On February 12th, I wrote, of our PM,

"If he is to hang up his boots with any sense of achievement, visibly combating corruption could be his chance to go down in history."

 And, that,

" If my speculations are correct, then Manmohan Singh  has sent word out that the fight is joined. 10 Janpath has been warned. There is little Sonia can do but back him. She has no power to restrain him; the worst she can do is sack him. Since he has no political dynasty to perpetuate, and no skeletons in his cupboard, she has no hold over him. However, his departure at this time would threaten the stability of her government."

 

Since then, the Anna Hazare gang has tried to create measures to become super-cop and super-judge. Between the rifts in so-called civil society and the inevitable assertion of the establishment, the powers of the Lokpal will not be quite as far-reaching as this petty autocrat wants. 

 

Meanwhile, I continue to get he sense that Manmohan is coming down harder and harder on corruption. 

 

1.Sanjay Chandra, the CEO of Unitech, is in jail, in connection with the 2G scam. And, even while their boss is out, 3 of Anil Ambani's senior executives are behind bars. If the case against Reliance Telecom has merit, he will join them; if not, they will be sprung.

2. The favour Mukesh Ambani has received from one dispensation after another is being withdrawn. The Directorate General of Hydrocarbon (DGH) is openly censuring his company's operations in the KG Basin, and talking of levying fines on him. Barely 2 years ago, when our Comptroller and Auditor General compiled findings to the effect that RIL's expenses in the KG basin were 'gold-plated', the report was put aside. Today, the DGH is openly talking of not structuring RIL's return to compensate for these questionable investments. And, to make their intent clear, they have asked RIL to dig 10 more wells. Oh, and when RIL declared two petroleum finds in a PR exercise to reduce atention to their below-par quarterly numbers, the DGH was incredibly fast off the blocks in declaring that these finds were not commercially viable.

Clearly, the knives are out against Mukesh Ambani. I have been getting a sense of this estrangement between 10, Janpath and Sonia for over a year now. I have been speaking about this to others in the investment business' one well-connected investor said this was not a tenable surmise, as 10 Janpath is heavily invested in RIL. But. to his credit, he sniffed around and got back, saying that something had changed.

3. This morning's front-page story in the Delhi edition of the TOI spells out the steps that the department of Revenue Intelligence is taking against those who keep money in tax havens abroad. Direction came from the Supreme Court, but the depth and width of work that has been done speaks of major support from the executive:

 

- 18 lakh trips to destinations known as tax havens have been identified.

- 2 'individuals' who have made 60 trips each during the last year have been identified. That is an amazing amount of sifting.

And, this paragraph: "Among the legitimate travellers, officials don't rule out presence of corrupt bureaucrats and politicians who have someone else footing their credit card and hotel bills during their stay abroad. All such cases are being identified".

There are more than stirrings afoot. The pot has been poured into a mixer, and the speed will be turned up.

I hope.

Why Bernanke is unconcerned about inflation

 India is wrestling with inflation, and much of this is attributed to the flood of global liquidity, wrought by a US Fed, which is determined to create asset price inflation in the home country. This determination is rooted in:
- the surge in bank 'assets' in 2003-07
- the rapid depreciation in the value of these assets in the 2008 meltdown
- Fed support for these assets through unprecedented bail-outs for the sector

Now the US banking system desperately needs clarity on the value of these assets, which are currently marked-to-model (convenience) rather than the more rigorous mark-to-market that can be the only prudential norm.

The question, then is whether the US, too should not be concerned about inflation feeding through to the economy, especially when so many are unemployed. The literature is full of studies that show this will not happen.

I am not convinced:

http://www.bostonfed.org/economic/ppb/2011/ppb111.htm

The barbarous relic may have some use - yet

Indians own an estimated 18,000 tons of gold, the World Gold Council estimated in October 2010. On the last trading day in April 2011, gold traded at a little over 50,000 dollars a kg, or 50 mn USD per ton. Rounding the numbers off for simplicity, that's roughly 1 trillion dollars of gold.

A lot - that's roughly 3 times our FX reserves, which actually only just balance our FX borrowings.

I have had this thought for a while that, if the global financial imbalances lead to further currency volatility, one of the fall-outs will be much higher gold prices. A nation as dependent on commodity - particularly petroleum - imports as ours will be badly hit if raw material prices continue to surge. If the crisis gets really deep, I have this gut feel that our private holdings of gold will have to be mobilised to bail us out.

Our government is grossly under-prepared.

Low interest rates distort the economy

Rajiv Kumar, who heads an industry association, and Surjit Bhalla ("What inflation?") joined their pens this weekend to Deepak Parekh's plea for a dovish stance on monetary policy in response to surging prices. 

I will not join with them on theoretical discussions about flaws in our price collection mechanisms, except to say that past experience doesn't suggest that official data systematically pegs price rises too high. And I will agree with them that higher interest rates run the risk of slowing down investment in our economy.

However, I do not agree that concern about the latter should trap our policy makers in getting into a cycle of higher prices, higher government spends, higher deficits, and higher inflation expectations. In its role as the nation's biggest borrower, the government could easily settle into a cosy relationship with higher prices, leading to higher nominal tax collection, combined with negative real interest rates. This reduces the cost of being fiscally indisciplined.

From the viewpoint of the real economy, though, it increases the chance of a greater misallocation of funds - going into expenditure that does not increase productivity, but drives up demand, a la NREGA; or encouraging consumption of scarce resources being distributed at prices below cost, such as food, petroleum products and fertiliser.

When all nominal prices are rising, a sensible economist should be looking at how relative price movements drive the misallocation of resources. In India, ca. 2011, low real interest rates have encouraged a 7-year boom in up-market homes in our largest urban agglomerations. Today, they have stacked up to unsold stocks worth several years of sales at peak volumes. Similarly, cheap finance and cheaper diesel have encouraged a boom in sales of diesel cars.

These are gross misallocations of resources into a still poor nation. If our economic leaders will not discipline themselves, it is the role of our columnists and free-standing economists to do so. But the two I mentioned are respectively playing their lobbying role and talking their book.

Pity.

HDFC's interest in low interest rates

Mumbai home sales dropped to a 2-year low last quarter, according to real estate analyst Liases Foras, and logged 14% lower than the previous quarter, even while unsold units reached 105 mn. square feet.

In India's largest market, Delhi and surrounding areas, sales soared in contrast, by a whopping 32%; nevertheless, unsold units soared to 194 mn. square feet, roughly 2 years worth of sales at the current elevated levels.

This dynamic could turn explosive if the Reserve Bank of India (RBI) decides to actually pay people money to lend money to banks, rather than pay banks to borrow money from the RBI - which is what is happening today, when the RBI repo rate is considerably below inflation. The volume of economists - including the IMF - pressing the RBI to get tough on inflation is ratcheting up, even while the Chairman of HDFC, our largest housing lender, says that 25 bps (0.25%) is hike enough. Of course he would - who would like to see the cost of his major (only) raw material go up!.

This view, in an interview printed in the Mint this morning, is a lot better than another pious statement he made a couple of days ago, that the RBI is never behind the curve. That sounds a bit like his fellow Mumbaikars believing that Ganesh statues were drinking milk a few years ago. Actually worse, because in that case, it did appear that the milk was disappearing into the stone of statues. In this case, it would be pretty obvious to anyone who bought their own milk and vegetables that inflation is way ahead of the RBI's gentle incline. I guess Deepak Parekh doesn't.

Buy his own milk and fruit, I mean.

Dhoni holds down Gillette run-rate

I know, I know, Team Gillette doesn't play cricket. They try to sell blades. Their competition is not so much other blade brands as not shaving. Unfortunately, everytime the TV cameras zoom in on Dhoni or Sehwag, they show a grizzly, unshaven face. It's almost as though it's not manly to go about with a clean-shaven face. When the stars of the other Indian galaxy pose at their premieres, they're unshaven too - Abishek Bacchhan and Hrithik Roshan. The only prince of our political world, Rahul Gandhi, is most often seen with a two-day stubble.


Gillette has tried to fight 'Not Shaving' with a campaign saying women prefer men who shave regularly. Its a hard slog when their competition is the pantheon of young Indian gods. In the last quarter, Gillette spent Rs. 73 cr. on advertising, a staggering 28% of revenue for the quarter. In my book, anything over a 10% spend on advertising is already aggressive. I have nothing against aggressive, especially when the parent company has deep pockets, and a virtual monopoly in many markets. The cautionary sign, though, is that sales growth is not electric - at 20%, it does stand apart from growth at Nestle, for example. And yet, the Price-Earnings multiple for Gillette now stands at over 60. Much too pricey, by my reckoning.