2014 Could Likely Be a 2008 Housing Repeat

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After fretting over mortgages for close to a decade now, we still cannot escape the wincing throes of the housing bubble. I should actually be more specific in that regard, as it now appears closer to reality that we will actually experience a second revulsion in housing in 2014 very similar in mannerism to a bubble collapse. This second event has been nowhere near the scale of the original, except in acceleration of prices. It may not be common knowledge, but house price indices of various styles have shown faster acceleration in 2012 and 2013 than in any comparable periods during the "big one."

You can't tell from the mainstream, but mortgage finance has all but collapsed in only a few months' time. Since the Federal Reserve provoked credit markets in May 2013 with only ephemeral threats of tapering QE, gross MBS issuance is off more than 53%; February's pace was just $87.2 billion (according to SIFMA). Worse than that, MBS repo volumes have collapsed 56.8% over that period, to a rate of just over $1 trillion per month (submitted for clearing). Agency repo volume is down 63.2% as well.

Relatedly, recidivism in mortgage modifications was nearly 30% of the more than 1 million that ended up in HAMP and HARP. That sounds bad, and it is far from good, but that actually represents significant improvement. When the OCC first began to track redefaults through mortgage mods back in 2009, the redefault rate was an astounding 55%. It has fallen since that time, with most of that "improvement" coming in 2012 and 2013.

As you might surmise from the timing, redefaults are highly correlated with housing prices. The reflation in real estate, fed in no small part by Fed-financed institutional buying in bulk at auctions of distressed properties, has provided the cover for mortgage mods to progress, but not in the manner consistent with the ultimate aims of the program. The design back in 2009 was to help people keep their homes, not to help people keep their homes only if prices accelerate at a rate exceeding the last bubble.

In other words, should mortgage finance prove predictability with regard to future housing prices (as it did the last time), then recidivism is likely to return toward the original rate. Worse still, those will likely be joined by the ranks of many more caught in a new price trap.

That pretty much sums up the state of the current recovery, a simple reflation that subsumes little else other than repricing assets. GDP growth in 2013, for whatever that means, was the weakest since 2009, yet credit growth in the corporate sector busted through the 2007 peak. That was particularly true in high yield debt, which includes, infamously, leveraged lending.

Anyone not familiar with leveraged loans should simply know that the borrowers are "low quality" companies that obtain funds through bank syndications. Yes, they are very much like securitizations of subprime mortgages. Total new issuance in 2013 was a record $600 billion, to go along with $350 billion in new junk bonds. Nearly $1 trillion in new debt for low quality companies with what to show for it, economically speaking?

I should clarify that my interest in this new "subprime" does not relate to any expectation for a renewed bank panic or financial crisis, only in that credit has become a hamster wheel of the financial economy in its relation to the real economy. It may not be as clear here in the United States, owing to the blackout in the media regarding this and every other monetary mistake of the past six years (or even past few decades), but it is very obvious in what is transpiring in China. The two are more than analogous, as the Chinese reversal portends much about the state of the US system.

Indeed, how can it be anything other than very fragile where a small increase in mortgage rates, based on nothing more than hyperbole and inconsistent cajoling, should produce such an outsized collapse in mortgage finance? That is confirmed by the observation about redefaulting, in that the ultimate disposition of modifications really should not be dictated almost completely by real estate prices. The state of these credit markets and the economy in which they are supposed to support do not appear robust in any fashion.

Most of that has been apportioned by bad theory, badly put into practice. It extends beyond simply the overconfidence evident inside the FOMC, but rather to miscalibrations from the very start. In the very first discussion about QE, in December 2008, Chairman Bernanke argued, I assume with a straight face, that the coming programs should not even be called as such. His reasoning was:

"So I would argue that what we are doing is different from quantitative easing because, unlike the Japanese focus on the liability side of the balance sheet, we are focused on the asset side of the balance sheet. In this case, rather than being a target of policy, the quantity of excess reserves in the system is a byproduct of the decisions to make these various types of credit available."

I find it very easy to agree with the part of Chairman Bernanke's assertion where excess reserves are labeled a useless byproduct of monetary "easing", but I would also very confidently assert that is not the only useless creation. I have no doubt that the monetary textbook defines a significant distinction between asset side and liability side intervention, but in the real world it is a distinction without a difference. And, as an aside, the FOMC at that time was intimately acquainted with the Japanese version of QE, having ridiculed it in 2003 - suggesting another motive for both removing the common label and the target itself.

I think a detour into monetary history can help illuminate this point, where interference is interference no matter where it ends up. I often reference the eurodollar market because its role in global finance is underappreciated by everyone from disinterested observers to policymakers themselves. The "closing of the gold window" in 1971 is relatively wellknown, but there is a curious incuriosity about what took gold's place to cover international exchange.

In the late 1960's, the Federal Reserve was downright hostile to the eurodollar market because they saw it as a channel for worsening the current account situation. Part of that stemmed from misunderstanding, but also from the operational framework under Bretton Woods. In January 1971, only eight months from Nixon's unilateral suspension of convertibility, the FOMC discussed the eurodollar problem at some length.

"Also, a memorandum of his [chief international economist Robert Solomon] that had been distributed to the Committee on December 9, 1970, outlined the nature of the problem, commented on the potential for further outflows of Euro-dollars, and discussed the possible consequences of lack of official action to stem the outflow. He would not comment at length on those matters today, but it was worth repeating his observation of this morning that the official settlements deficit for 1970 now appeared likely to be between $10 billion and $11 billion. It was impossible to say what further outflows would occur in 1971 in the absence of official action, but they might be on the order of $4 - 5 billion."

It was agreed that the magnitude of such outflows into the eurodollar market would only enhance the convertibility doubts that were eroding gold trading even as early as the sterling crisis of 1967. As the FOMC further granted, such outflows would only "trigger heavy speculation against the dollar."

It must be understood at this point that the evolution of the eurodollar market itself owed entirely to regulation. Further, these outflows were directly proportional to the inability of banks to domestically compete as they were undermined by Regulation Q. In broad terms, the rate differential between these dollar markets made it too expensive for American banks to retain funds domestically, particularly as German banks were sourcing so much of their dollar needs on market in London eurodollars (rather than through domestic banks).

But the rise of eurodollar trading was not simply a "market" response to regulatory arbitrage and interest rate differentials. Central banks had also begun to use the eurodollar market to essentially circumvent the gold exchange standard. At the August 1971 FOMC meeting, only nine days after the gold window suspension, Vice President of the Foreign Operations Department Charles Coombs noted,

"The swap lines were frozen; so was the IMF; the status of the SDR's was highly questionable; and no foreign central bank would sell gold at $35 an ounce except in the most dire emergency. All that remained of international liquidity available for use at the moment was inconvertible dollars, of which there was no shortage of supply; rather, there was an acute shortage of official buyers."

The largest presence in those early eurodollar days were the central banks themselves. As this floating, fiat system progressed the importance of central bank flows became even more paramount than they had been in the 1960's. For example, in 1973 the Federal Reserve had been engaging in dollar swaps with the Bank of Italy but only in three-month terms. By January 1974, the Bank was apparently tired of having to roll them over and simply borrowed "dollars" in the eurodollar market and retired the swaps entirely.

Earlier in 1973, the British government had been openly committing to a "clean float" of sterling, but suddenly changed with the prospect of a large devaluation (again) facing them. In response, to manage the float, the Bank of England, through the British Prime Minister's office, authorized the nationalized industries in Great Britain and some local authorities to borrow $2 billion of "medium-term money" in the eurodollar market solely on the condition that those "dollars" be sold back to the Bank of England. It was essentially a bypass for which the Bank of England could defend sterling without publicly resorting (again) to Fed swap lines.

In the middle of 1971, Paul Volcker, then Treasury Undersecretary, traveled to Amsterdam to convince the Dutch to stop converting dollars into gold. He met with Dutch economist, Dr. Jelle Zijlstra, the head of both the Bank for International Settlements and De Nederlandsche Bank (Holland's central bank). There Dr. Zijlstra famously retorted to Mr. Volcker's exasperation to "not rock the boat" by stating the fragility very clearly, saying, "If the boat is rocking because we present $250 million for conversion into gold or something that can be considered an equal asset, then the boat has already perished."

By 1974, however, Dr. Zijlstra was quoted in an FOMC meeting as conveying, "In the absence of international controls, the Euro-dollar would seem to resemble a currency working under a system of inconvertibility and according to the criteria set by the commercial banks themselves."

Later in December 1974, the committee had finally come to terms with the eurodollar market. Charles Coombs had even argued for its inclusion in official money supply figures,

"[H]e suspected that at least some part of the Euro-dollar-based money supply should be included in the U.S. money supply. More generally, he thought M1 was becoming increasingly obsolete as a monetary indicator. The Committee should be focusing more on M2, and it should be moving toward some new version of M3--especially because of the participation of nonbank thrift institutions in money transfer activities."

In adopting the eurodollar market, the Fed, like it would with QE decades later, reversed itself, rationalizing the new policy position as wholly different than the old when in fact the sudden imposition of true markets ultimately determined the outcome. In that sense the parallels are quite striking, as Dr. Zijlstra pointed out in 1971 that the dollar had already been broken, as dollar and regulatory tinkering via official policies (to be fair, that included the Treasury and fiscal irresponsibility) had produced a fatal frailty. And in 2008, monetary authorities essentially stumbled into a course of action that had already been set in motion. But rather than rectify their errors, they compounded them by not allowing true markets to actually work out these imbalances. Instead, policy changes forced upon policymakers by market rebukes only crystalized those imbalances, preserving their insidious nature to be unleashed at future moments (in perpetuity, it would seem).

The 1970's were a disaster globally, including the eurodollar adoption that exploded debt and monetary "reserves" throughout the world, producing concentrations in places like the OPEC nations. There were a whole host of drastic crises that are largely ignored in the official narrative, one after another, throughout the so-called Great Moderation - from Latin Debt, to Mexican pesos, to Asian flu and Russia, to the asset bubbles and beyond. Instead of producing the monetary panacea, the system they undermined was replaced by one equally fragile and drastically more dangerous.

I would extend that narrative of brittleness to the economy as it operates now. Despite bubble-type pricing of reflation throughout asset classes, in an upside down pyramid where the most risky assets now exhibit the most stable, rising prices, the economy continues to move in the "wrong" direction. Indeed, it has taken such an "unexpected" course that orthodox economists are left to blame rolling Polar Vortices for such weakness. If the economy had actually regained solid footing in this "recovery", cold weather would be a minor nuisance rather than a major depressant. When you combine all these results, mortgage fragility and reflation, the "snow" economy, the common theme is exactly that - robust is a word now banished from the economic lexicon.

That is the true distinction here. Make no mistake, I am not trying to say that there were no crises, monetary and otherwise, during the Bretton Woods or gold standard eras. Only that those crises never prevented robust economic growth and structure. That seems to be the obvious difference here, in that we still have crises that may have intensified, but that growth is increasingly harder to find. All you have to do to see this in motion is average growth rates by decade, and pinpoint where that chronology begins to decelerate (hint: bell bottoms and disco). The decade of the 2000's was the worst in history (by a combination of measures).

Some economists try to explain that as a combination of exogenous factors, including the end of a string of innovative revolutions - the low hanging fruit having been already plucked. Since I think capitalism and free markets produce a nearly endless string of innovation, I find it lacking in sufficient explanatory power. The obvious answer, to me, is exactly as I have described here - these monetary mistakes, persistent and unending, create an inefficient fragility that, not unlike a vortex, consumes resources that might very well be dedicated toward fostering revolutionary innovation rather than simply trying to keep the whole unseemly mess afloat for a little while longer.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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