Moon of Alabama Brecht quote
December 06, 2007

The Debt Bubbles and Interest Rates

The public attention is still on the default of subprime mortgage loans. There the defaults are further increasing:

One in every five adjustable-rate subprime loans had late payments in the quarter, a number that excludes the one of every 10 already in foreclosure, the trade group said. Foreclosures started on all types of mortgages rose to an all-time high of 0.78 percent from 0.65 percent.

When you can get Two Houses for the Price of One something is indeed very wrong.

The parameters of the mortgage rescue operation by the "broad coalition", i.e. Wall Street, have been released. The idea is to forestall interest increases on some Adjustable Rate Mortgages for some time. The announced plan is quite restrictive, legally flawed and will likely be ineffective:

Barclays Capital — extrapolating from a similar program recently unveiled in California — estimates that only about 12 percent of all subprime borrowers, or 240,000 homeowners, would get relief.

The Citigroup bailout via a 'Super Fund' for Structured Investment Vehicles is, like I expected, going nowhere. The size of the plan has been halfed to $50 billion and, as predicted, the three involved banks have found no one else who will take part in this looser scheme.

The credit problems are widening. The banks securitized all kind of loans and sold them off as Collateral Debt Obligations. Mortgages defaults are up. Now auto loan defaults are increasing. In the next step securitized credit card loans will follow. People who can not pay their mortgage also can not pay for their car or balance their credit cards. Student loans are another problem. When the economy slows down, defaulting commercial loans will add to the shitpile of bad debt.

The inappropriate lose credit standards, induced by much too low central bank rates in 2001-2006, were extended to all types of credits. The inevitably higher default rates of such lose credits were inexcusably not anticipated by the rating agencies and CDO investors.

Here is a nice flash animation explaining the CDO mechanisms. Mortgages and other loans were bundled, chunked up and classified by estimated default rates. These CDOs were sold off to various investors. Credit repayments first gush into the 'top bucket' of AAA rated CDOs. The overflow fills the lower buckets of Aa rated CDO's and so on. If the mortgage payments slow to a trickle, the lower buckets will stay empty and their value trend to zero. That normally wouldn't be a problem, but when many mortgages default, even the Aa buckets or even the top class AAA buckets will have losses. This is where we are right now.

The situation was certainly not unforeseen. This interesting NYT piece explains how many big banks, especially Paulson's Goldman Sachs, insured or sold their own holdings of risky CDO papers while marketing the same junk to pension funds and other dumb investors. Now these investors and their clients are in trouble.

With defaults and dubious investment holdings all around, the economy is in deep trouble. To prevent or at least cushion the economic downturn Roubini called for the central banks to lower interest rates. All of them, except the European Central Bank, seem to follow that advice.

I regard this as pushing on a string with bad side effects. Let me explain.

In normal times the central bank sets an interest rate which is the price big international banks pay to borrow from the central bank. The big banks add a bit to the interest rate they have to pay and then loan the money to other banks. From there the new creditlines are given to manufactures etc. who can use the money in their operations and hopefully make a return above the rate they have to pay. (This is simplified, but the principal holds.)

The lower the central bank sets the rate, the more likely manufacturers will use the cheaper money to invest and make a profit on these new investments. A rate decrease induces an increase in economic activities.

When the economy runs too hot and prices go up because all capacities are in full use, the central bank will increase its interest rate to cool the economic activities and to stop the inflationary tendencies.

It takes somewhat between 12 to 18 month until a rate change is measurable as a change in economic output.

But the model has two problems.

If the cheap money the FED is pushing into the economy is invested in non productive issues, asset bubbles occure. This was the case between 1995 and 2000 in the tech stock market and later in housing and consumption. The manufacturing investment did happen too - not in the U.S. but in China. The classic central bank theories stop at the boarder and are thereby somewhat flawed.

The second problem in the central bank model is the assumption that the lending between banks pushing the cheap money into the markets is reliable and occurs with only a modest addition to the central interest rates.

The London Inter Bank Offered Rate is the rate one bank will charge the other for an unsecured loan. Usually the LIBOR is a constant bit higher than the central bank rate. But with the defaulting CDOs and lack of knowledge about who owns such junk, banks have stopped to trust each other.

Who knows how creditworthy the counterpart really is when there is so much bad debt around?

Bank A now demands a high risk premium for any loan it may give to bank B. The difference between the central bank rate and LIBOR is therefore now much higher than usual. It is no longer driven by the central bank rate, but only by fear of a possible counterpart default.

The normal FED easing mechanism is broken. Even if the central banks lower rates the interbank rates will not decrease.

This will only be fixed when banks start to trust each other again. As long as banks and other entities do not fess up about their debt and their losses on CDO holdings, the trust will not come back.

Any lowering of the FED rate will not fire up the economy but the big banks will take the money and put it into vaults or invest it into secure assets, most likely commodities, and thereby increase general inflation. The resulting economic state is known as Stagflation.

So my reasoning is different than Roubini's. He seems to believe the system still works: lowering of the central bank rate will help to cushion the recession and induce new economic activity. He disregards any clear possibility of higher inflation.

Like Jim Rogers I believe that any lowering of the central bank rates will push money not into the productive economy, but into some unproductive assets class, likely commodities, and induce another bubble there. The summary effect is increasing inflation in a recessive or stagnating economy.

Only renewed trust between all economic entities, banks, manufacturers and consumers can repair the system. To regain this trust, the bad entities have to be shaken out. A real recession will do this. Any attempt to cushion it, by some half assed rescue schemes for faulty mortgages and bad investments, or by near zero-interest central bank money, will likely prolong the pain while at the same time inducing very unhealthy side effects, i.e. inflation.

Posted by b on December 6, 2007 at 17:29 UTC | Permalink


Your scenario reminds me of the time around 1980 when mortgage rates were up near 20% for awhile and the local bank paid maybe 5 or 6% on savings.

Posted by: rapt | Dec 6 2007 22:31 utc | 1

I regard this as pushing on a string

Exactly. Almost certainly guarantees a Democratic win in 2008, with higher unemployment, consumer debt defaults, bankruptcies, food and fuel shocks. The Republicans are finished as a moral authority.

The wild card is Israel. If they attack Iran, we'll see a global equity/credit crash, no different than 29.


Posted by: Wolf DeVoon | Dec 6 2007 23:31 utc | 2

I have a tangential question (in reference to previous posts on Ron Paul)
Can modern economies work without central banks? In other words, instead of a cartel of 12 private banks fixing interest rates backed by the government, i.e. taxpayer,could we have the big banks borrow and lend at their own risk in a competitive market?

How about a gold standard, or, in lieu of such, removal of all taxes on the sale of gold and silver to permit their use as currency alongside federal reserve/central bank notes?

Posted by: lysander | Dec 7 2007 2:08 utc | 3

I read Investment Biker when it came out [for the biker part]. At that time Rogers invested in breweries all around the world. The last time I read about him he was investing in China by having his 18 month old child tutored in Mandarin.

Chinese breweries?

Posted by: beq | Dec 7 2007 2:22 utc | 4

Can modern economies work without central banks? In other words, instead of a cartel of 12 private banks fixing interest rates backed by the government, i.e. taxpayer,could we have the big banks borrow and lend at their own risk in a competitive market?

Hmm - yes, but there are some negatives too it. The Fed is "the lender of last resort". That can help when a bank is temporarily in trouble. Such can happen and it would be somewhat unfair to everybody if a big bank goes down because of rumors and temporary problems. So there is a role for a Fed.
But todays construct is much different. The Fed now is tasked to keep the stock market up and the raptors rich. The Fed doesn't allow recessions anymore. That gave us the tech bubble and the housing bubble. Part of the problem is that the Fed is privatly owned. There is no need for that to be so. The other problem is that the Fed has two official tasks - keep inflation down and keep the economy growing. The ECB only has the first task. It is not mandated to prevent recessions which are needed sometimes to clear out the brush.

How about a gold standard, or, in lieu of such, removal of all taxes on the sale of gold and silver to permit their use as currency alongside federal reserve/central bank notes?

A real gold standard is likely no longer possible. The thing the gold standard never really worked out is international currency handling. The Gold standard is of cause also a huge advantage for countries who have Gold in the ground against countries who have not. There are some alternatives, like a currency indexed to a basket of traded commodities. There are lots of ideas about this out there.

Posted by: b | Dec 7 2007 7:27 utc | 5

Hope your money-market fund, pension or county administration doesn't hold any of this junk: Top CDO Classes May Lose 80 Percent, Barclays Says

About 20 percent to 30 percent of principal would be covered for the "super senior" portions of mezzanine asset-backed bond CDOs, which mainly contain mortgage bonds and other CDOs initially assigned low investment-grade ratings, Barclays said in the report yesterday. The senior-most classes of CDOs containing highly rated asset-backed bonds would recoup 30 percent to 65 percent, it said.

Posted by: b | Dec 7 2007 7:27 utc | 6

Can someone please explain to me the purpose of having a Government, a Congress, ... ???

While that hard-core lefty site dailysoros revs up the masses to the task of electing people's candidates...

Posted by: jj | Dec 7 2007 8:49 utc | 7

Have any "true" conservatives come out against Bush's rescue plan as an example of government meddling in private affairs?

A true laissez-fair neoliberal would point out that nobody forced those folks into taking out those loans, nobody prevented them from reading the fine print, and last of all, nobody prevented other investors from buying into those sub-prime mortgage bonds.

How else are people & institutions going to learn from their mistakes unless we allow them to really fall on their faces? Are we turning into a fiscal "nanny state"?

Posted by: ralphieboy | Dec 7 2007 12:53 utc | 8

Thanks for the explanations... The peculiar thing in my mind about ‘relief’ plans is their post hoc and ad hoc characteristic, as if twiddling about with all this complex finance will do anyone any good (which it may not even be meant to do). A bit like a dysfunctional family that decides that junior can have more money for *outings* and then will no longer be a scary threat. Three weeks later the family is in turmoil again because 700 has gone missing and meds for juniorette cannot be bought. And so on.

What I can’t fit together is the new US bankruptcy laws and how they and the foreclosures will affect families. In an ideal ‘sane’ systems, bankruptcy is declared, banks and other financial institutions shoulder the loss, and ‘relief’ comes from ‘outside’ that system, from various places, such as the Gvmt./tax payer (subsidized cheap housing) associations who provide tents, etc.

Another myth about Amerika bites the dust - You can start over - not. How many millions are living in a barter economy hiding from banks, the IRS, and authorities or any kind? Without health care; for some, schooling for children?

My retrograde indignation is quaint, ..

Ponzi schemes and other scams built on illusory returns or interest bite the dust. Bubbles burst. The trick is to keep the loosers afloat and still coming in, working. Angry hordes with guns in the street, starving children won’t do.

Posted by: Tangerine | Dec 7 2007 16:52 utc | 9

Easy fix to fund some of these 'rescue' plans: Reduce the mortgage interest deduction for high-end properties. Start with say, 150% of the conforming limit of $417K and taper down the deduction 5% every 100k.

Posted by: biklett | Dec 7 2007 18:45 utc | 10

UBS lost some change ...

UBS writes down $10 bln, Singapore injects capital

Swiss bank UBS unveiled $10 billion in shock subprime writedowns on Monday and said it had obtained an emergency capital injection from the Singapore government and an unnamed Middle East investor.

UBS, which has been severely battered by the U.S. subprime mortgage meltdown, issued a profit warning and cancelled plans for a cash dividend in moves that depressed the company's shares and those of its rivals.
The two new investors will subscribe to an issue of mandatory convertible notes carrying a coupon of 9 percent until conversion into ordinary shares, which must take place within approximately two years of the issue.

A financial source said the coupon was exceptionally high. "It shows what a pitiful state they are in," said the source, who asked not to be identified.
The GIC manages Singapore's foreign reserves. It told a news conference it was premature to say whether it will have a seat on UBS's board, although it expects an offer.

Posted by: b | Dec 10 2007 11:36 utc | 11

Weird day today. It was obvious for several days that the fed would go down 0.25%. All option measurements in the bond market pointed to this and not to a 0.5% interest cut.

But when the fed did what was widly expected the stock market tanked 2.5%. It seems to have had the illusion that the fed would cut more. This tells something on how far the stock market is away from reality.

Posted by: b | Dec 11 2007 21:14 utc | 12

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