Monday, July 9, 2007

How much of a worry should subprime mortgages and collateralized debt obligations be?

Maybe even more than I’ve written before.

First, according to Counterpunch, financial derivatives have 10 times the float of all publicly traded stocks combined. That’s a lot of dinero, and no matter how much the Dow is up, ultimately, the broader investment market just can’t run from that:

Noriel Roubini puts meat to these bones. In his June 27th blog, Roubini wrote:

“The fallout of this CDO mess is likely to end up into $100 billion plus of losses for banks, financial institutions, hedge funds and investors once these CDOs and subprime mortgage backed securities are marked-to-market rather than being marked-to-a-delusional — misrated-model. Thus, the Bear disaster is only the tip of the iceberg of a much bigger financial mess that will unravel in the next few months: the pile of rising subprime and nearprime delinquencies will take a toll on the toxic waste of mortgage backed securities that a rating ‘voodoo magic’ pretended to turn below-junk securities into A-rated ones.”

Meanwhile, the Bank of International Settlements is worried about how the Fed has first mishandled this situation, then hedge funds. (Are hedge funds being used to “vent” the subprime crisis just like Greenspan used housing to ‘vent” he dot-com bubble?)

Here’s just how bad the problem is:
The BIS referred to the toxic effect of the $470 billion in collateralized debt obligations (CDO), and a further $524 billion in “synthetic” CDOs which have spread through hedge funds industry. These CDOs are the loans (many sub primes) which were bundled off to Wall Street and turned into securities which are highly leveraged in hedge funds for maximum profitability. As Bear Stearns is discovering, these CDOs are like roadside bombs. …

Banks doubled the amount of CDOs outstanding in the past two years to $2.6 trillion, including a record $769 billion sold last year, according to J.P. Morgan.

And, just because Wall Street is doing fine, that doesn’t mean the economy is so great, in case you’re wondering how it can be looking at 14,000 in the face of all that debt:
The current rise in stock prices does not indicate a healthy economy. It simply proves that the market is awash in cheap credit resulting from the Fed's increases in the money supply. Consumer spending is a better indicator of the real state of the economy than stocks. When consumer spending drops off; it is a sign of overcapacity, which is deflationary.

Here’s the bottom line:
The underlying problem is not simply the Fed's reckless increases to the money supply, but the growing “wealth gap” which is undermining solid economic growth. If wages don't keep pace with productivity; the middle class loses its ability to buy consumer items and the economy slows.

The reason that hasn’t happened yet in the US is because of the extraordinary opportunities to expand personal debt. The Fed's low interest rates have created a culture of borrowing which has convinced many people that debt equals wealth. It's not.

On mortgage refinancing, the purchasing of second homes as investments, etc., that confusion of wealth and debt is now coming home to roost.

And, if that’s not enough to wake you up:
The rise in housing prices has created the illusion of prosperity but, in truth, we are only selling houses to each other and are not making anything that the rest of the world wants. The $11 trillion dollars that was pumped into the real estate market is probably the greatest waste of capital investment in the nations' history.

Harsh words, but at least a fair-sized grain of truth behind them. This reminds me of Paul Kennedy’s book “The Rise and Fall of the Great Powers.” Somewhat for the Netherlands, and definitely for Great Britain, Kennedy states the move from manufacturing and industry to a focus on financial services was a key part of the decline of these great powers.

Caveat emptor.

Cross-posted at Socratic Gadfly.