[GJM] "The Unraveling: Described by Hyman Minsky, provided by Roubini" [a CITS Capital & Debt Watch]
W. Curtiss Priest
bmslib at mit.edu
Tue Jul 31 14:22:51 MDT 2007
** **
W. Curtiss Priest, Ph.D.
Center for Information, Technology & Society
466 Pleasant Street Melrose, MA 02176
E-mail: BMSLIB at MIT.EDU, Voice: 781-662-4044, FAX: 781-662-6882
July 31, 2007
Public Issue #129:
CITS DEBT WATCH
"The Unraveling: Described by Hyman Minsky, provided by Roubini"
Commentary by Dr. W. Curtiss Priest, Director:
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Previous issues of the CITS DEBT WATCH:
http://groups.google.com/groups?q=cits+debt+watch&hl=en&scoring=d
The entries appear in reverse chronological order, with the
most recent, first.
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I appreciate Roubini's caution that "it is always risky to call
an equity market peak."
Indeed, I believe Ravi Batra's prediction of a depression
starting in the late '80s was sorely confounded by:
1. a very innovative group of "new financiers" and their
ability to outfox the regulators
2. a nation-wide rise in house prices, the likes of
which we have never witnessed, coupled with the insanity
of lenders, sub-prime, "re-fi," "cash-out," and by
various other disguises by which "upright American
citizens" "sold the farm" and then some
We shall not subscribe to the notion that, just because the
event did not occur when Batra (and many others) sensed
the precariousness of our financial house of cards, that the
event was "not to occur." Rather, we do subscribe to the
writings of Davidson and Rees-Mogg, that, by delaying the day
of reckoning, that reckoning will only occur with greater,
hurricane-like forces.
It is much like thunderstorms. If daily showers dissipate the
sun's energy, we have fairly calm storms. However, if the
energy is allowed to accumulate, and come all at once, we
expect to see many trees struck and torrential rains and
considerable flooding.
So, we expect, soon I believe, to see many houses as if
struck by lightning, and an unfolding of debt/credit recalls
that will reveal the magnitude of the storm.
What I appreciate about Minsky's description about this is
his distinction between three groups. Those who have the
resources to cover debts, those who are "speculative borrowers"
who can only service debts out of cash flows, and then those
who are Ponzi-like, needing ever increasing debt burdens to
finance and repay prior debts.
So, this view tells us precisely how the next stages will play
out. While the stages will not be sequential, but rather,
tightly coupled, we know that the Ponzi-like folk are already
causing an implosion. Now, those who depend on incomes to
service debts will be directly affected as they find that
the whole class of Ponzi-like debtors can no longer afford
goods and services, and those depending on an income stream
will see their streams diminish, and thus force many of them
to default. Finally, we get to the point where even the
borrowers with best intentions are hit. We get to a point
where FDIC can no longer pay for all of these failures, and
so FDIC insured, "safe," money is unavailable. Surely, some
day, maybe some decade, FDIC will finally make good on their
insurance, but, with much less than $1 for every insured $100
dollars, the system is not designed for catastrophe.
Meanwhile, by Executive Order, George W. Bush will convert
all 90 day treasuries into 30 year bonds. I've been told
he has the authority to do this. So, everyone holding treasuries
are simply holding IOUs, which the US Federal government can
get around to covering over 30 years. But, ohmi, so much
damage can occur in even ten years.
Now we take the nearly $100 trillion in Federal liabilities
and obligations (including FDIC, medicare, medicaid, new
prescription benefits, pension guarantees, etc.) and, as
Walker, head of the General Accountability Office, has been
politely trying to inform people, even in the best of times,
that there is no money to cover all of these liabilities
and obligations. Now imagine the worse of times.
W. Curtiss Priest, Editor
CITS Capital & Debt Watch
P.S. my thanks and gratitude for:
PinHawk NewzDigest <economic at pinhawk.com>
and their review of financially relevant blog material
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["fair use," "teachable moment," "archival," Section 107(a), 1976
Copyright Act and 1998 Digital Millennium Act]
Nouriel Roubini's Blog
Are We at The Peak of a Minsky Credit Cycle?
Nouriel Roubini | Jul 30, 2007
It is always risky to call an equity market peak and the beginning of
a bear market in equities; so I will not try to do that. But leaving
aside equity valuations, it increasingly looks like we are at the peak
of a credit/debt cycle, in the US and globally.
Specifically, the crucial macro question that we should ask ourselves
today is whether we are at the peak of a Minsky Credit Cycle. Or as
the UBS economist George Magnus - an expert of financial
instability - put it: "Have we reached a Minsky moment?"
Hyman Minsky was an American economist who died in 1996. His main
contribution to economics was a model of asset bubbles driven by
credit cycles. In his view periods of economic and financial stability
lead to a lowering of investors` risk aversion and a process of
releveraging. Investors start to borrow excessively and push up asset
prices excessively high. In this process of releveraging there are
three types of investors/borrowers. First, sound or "hedge
borrowers" who can meet both interest and principal payments out
of their own cash flows. Second, "speculative borrowers"
who can only service interest payments out of their cash flows. These
speculative borrowers need liquid capital markets that allow them to
refinance and roll over their debts as they would not otherwise be
able to service the principal of their debts. Finally, there are
"Ponzi borrowers" cannot service neither interest or
principal payments. They are called "Ponzi borrowers" as
they need persistently increasing prices of the assets they invested
in to keep on refinancing their debt obligations.
The other important aspect of the Minsky Credit Cycle model is the
loosening of credit standards both among supervisors and regulators
and among the financial institutions/lenders who, during the credit
boom/bubble, find ways to avoid prudential regulations and
supervisions.
Minsky`s ideas and model fit nicely the last two US credit booms
and asset bubbles that ended up in a recession: the S&L-based real
estate boom and bust in the late 1980s; and the tech bubble and bust
in the late 1990s. But the experiences of the last few years suggest
another Minsky Credit Cycle that has probably now reached its peak.
First, it was the US households (and households in some other
countries) that releveraged excessively: rising consumption, falling
and negative savings, increased in debt burdens and overborrowing,
especially in housing but also in other categories of consumer credit,
an increase in leverage that was supported by rising asset prices
(housing and, more recently, equity). We know now that many sub-prime
borrowers, near-prime borrowers and many condo-flippers were exactly
the Minsky "Ponzi borrowers": think of all the
"negative amortization mortgages" and no down-payment and
no verification of income and assets and interest rate only loans and
teaser rates. About 50% of all mortgage originations in 2005-2006 had
such characteristics. Also, many other households (near prime and
subprime borrowers) were Minsky "speculative borrowers"
who expected to be able to refinance their mortgages and debts rather
than paying a significant part of their principal.
The Minsky idea of loosening of credit/lending standards among
mortgage lenders - and the phenomenon of supervisors/regulators
falling asleep at the wheel while the reckless credit bubble occurs
- is also now evident in the recent mortgage credit cycle. A
supervisory ideology that tried to minimize any prudential supervision
and regulation and totally reckless lending practices by mortgage
lenders led to a massive housing and mortgage bubble that has now gone
bust. The toxic waste aftermath of this bust includes more than fifty
subprime lenders gone out of business this years, soaring rates of
delinquency, default and foreclosure on subprime, near prime and
non-conventional mortgages, and the biggest housing recession in the
last few decades with now home prices falling for the first time
- year over year - since the Great Depression of the
1930s.
While the process of releveraging started in the household sector
- that is the most financially stretched sector of the US
economy - the releveraging more recently spread to the corporate
and financial system: in the financial system the rise of hedge funds,
private equity and speculative prop desks led to a sharp rise in the
financial system leverage. In the corporate sector given the cheapness
- until recently - of credit we observed a massive process of switch
from equity to debt that took the form of leveraged buyouts, share
buybacks and privatization of formerly public companies. This
releveraging fed that equity/asset bubble: as expectations of more
LBOs occurred equity valuation of many firms went higher and higher.
The excesses took recently the form of premia of 40-50% or higher on
the stock price of firms that were a leveraged takeover target.
Specifically, CLO demand for corporate debt helped fuel the private
equity sponsored LBO wave over the past few years, and thus
contributed to the recent bull market in equities. Notice also that
the amount of issuance of low grade corporate bonds (below investment
grade "junk bonds") had been rapidly rising in the last
few years.
While pure "Ponzi" borrowers were not as common in the
corporate system, there is wide evidence of "speculative
borrowers" who relied and still rely on continued refinancing of
their debts. Ed Altman, a colleague of mine at Stern, is recognized as
the leading world academic expert on corporate defaults and distress.
He has argued that we have observed in the last few years record low
default rates for corporations in the U.S. and other advanced
economies (1.4% for the G7 countries this year). The historical
average default rate for US corporations is 3% per year; and given
current economic and corporate fundamentals the default rate should be
- in his view - 2.5%. But last year such corporate default rates
were only 0.6%, one fifth of what they should be given fundamentals.
He also noted that recovery rates - given default - have been high
relative to historical standards.
These low default rates are driven in part by solid corporate
profitability and improved balance sheets. In Altman`s view,
however, they have also been crucially driven - among other factors -
by the unprecedented growth in liquidity from non traditional lenders,
such as hedge fund and private equity. Until recently, their demand
for corporate bonds kept risk spreads low, reduced the cost of debt
financing for corporations and reduced the rate of defaults. Earlier
this year Altman argued that this year "hot money" from non
traditional lenders could move to other uses for a number of reasons,
including a repricing of risk. If that were to occur, he argued that
the historical patterns of default rates - based on firms`
fundamentals - would reassert itself. I.e. we are not in a new brave
world of permanently low default rates. He said: "If we observe
disappointing returns to highly leveraged and rescue financing
packages, some of the hedge funds may find it difficult to cover their
own loan requirements as well as the likely fund withdrawals. And
broker-dealers who are not only providing the leverage to the hedge
funds but whom are also investing in similar strategy deals will
recede from these activities." The same could be said of the
consequences of the unraveling of some leveraged buyouts. Altman
suggested that triggers of the repricing of credit risk could also be
"disappointing returns to highly leveraged and rescue financing
packages". So he argued that the unraveling of the low spreads in the
corporate bond market could occur even in the absence of changes in US
and/or global liquidity conditions.
Thus, until recently the Minsky "speculative borrowers" in
the corporate sectors included corporations that could service their
debt only by refinancing such debt payments at very low interest rates
and financially favorable conditions. While "Ponzi
borrowers" were those firms that, under normal liquidity
conditions, would have been forced into distress and debt default
(either of the Chapter 7 liquidation form or Chapter 11 debt
restructuring form) but were instead able to obtain out-of-court
rescue and refinancing packages because of the most easy credit and
liquidity conditions in bubbly markets.
The Minsky phenomenon of loosening credit and lending standards during
a credit bubble included both the corporate borrowers and financial
institutions. First, there are clear parallels between the mortgage
market and the leveraged loan markets. These include corporate
borrowers` high leverage ratios, declining credit standards
("cov-lite" loans instead of subprime), PIK (or
payment-in-kind) deals (variants of negative amortization),
insufficient monitoring by lenders due to the "originate and
distribute" model (loans repackaged into CLOs instead of CDOs),
banks` retained exposure (bridge loans as opposed to CDO equity
tranche). In the financial system, margin requirement for hedge funds
and other leveraged speculators became lower and lower as the
competition for prime brokerage services for hedge funds among lenders
became fierce.
Housing bubble, mortgage bubble, credit bubble, debt bubble and asset
prices (equities, housing, prices of corporate debt and other risky
loans) rising well below what could be justified by the economic and
credit fundamentals. It certainly looked like a typical Minsky Credit
Cycle. The first crack in this cycle was the bust of housing and of
subprime mortgages in the US. The second crack was the spread of the
subprime carnage to near prime and prime mortgages and to subprime
credit cards and auto loans. The third crack is the most recent
repricing of risk in a variety of credit markets and the beginning of
a credit crunch in the LBO and corporate credit markets.
We are clearly now observing a significant worsening in US financial
conditions and a peaking of the Minsky Credit Cycle in a variety of
markets:
- a housing recession that is getting worse by the day and home prices
now falling (for the first time since the Great Depression) as the
housing asset bubble has now burst.
- a credit crunch in subprime that is now spreading to near prime
(Alt-A) and prime mortgages (see the Countrywide financial results)
and to subprime credit cards and subprime auto loans;
- massive losses - at least $100b in subprime alone and most likely to
end up higher - in the mortgage markets;
- a significant recent increase in corporate yield spreads (by 100 to
150 bps);
- the beginning of a liquidity crunch in capital markets that starts
to look like the one experienced during the LTCM crisis (10 year swap
spreads are - at 70bps - at their highest levels since 2002 and close
to the levels that triggered the 1998 LTCM crisis);
- the effective shut down of the CDO and CLO markets as investors risk
aversion towards complex derivative instruments - whose official
ratings are clearly bogus given the subprime ratings debacle - is
sharply up;
- up to 40 LBO deals now in serious trouble (restructured, postponed
or cancelled) as the credit crunch is spreading to the leveraged loans
and LBO market;
- the overall increasing stresses in a variety of credit markets ("a
constipated owl" where "absolutely nothing is moving" is how Bill
Gross of Pimco described the effective recent shutdown of the CDO
market);
- credit default swap spreads being sharply up;
- the ABX, TABX, LDCX, CMBX, CDX, iTraxx indices all showing rising
risk aversion of investors, sharply rising credit default spreads and
significant concerns about credit risk in a variety of credit markets
(US, Europe and Japan corporate, high yield corporate, commercial real
estate, leveraged loans), not just in subprime or in mortgage markets.
Note also that, as Minsky - as well as more recently the BIS -
have warned the deflation of such credit-driven asset bubbles is
historically painful and associated with economic downturns and
recessions. So "Have we reached a Minsky moment?" It
certainly looks like it. Let me now explain why...
[further text via free subscription, at:
http://www.rgemonitor.com/blog/roubini/208166 ]
--
W. Curtiss Priest, Director, CITS
Center for Information, Technology & Society
466 Pleasant St., Melrose, MA 02176
781-662-4044 BMSLIB at MIT.EDU http://Cybertrails.org
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