LISTENER COVER FEATURE OCTOBER 18 2008

How bad is the global economic fallout likely to get and how will it affect us here?

As the world grapples with crumbling financial institutions that threaten to bring economies to their knees, the immediate priority is to ensure that central bank and government inertia, doesn’t amplify the downdraught. The financial system is in a hell of a mess and the cleanup required needs a ready flow of money to stop it getting so bad we plunge into another Global Depression.

That can sound highly dramatic from out here at the bottom of the South Pacific, with limited knowledge of this arcane world of structured finance, derivatives markets, swaps and short selling that seems to be holding us all to ransom. But the reality is that global finance has as as much influence on the future fortunes of New Zealand as it does on China‘s, let alone what we’re already seeing on Wall St, USA. After all, we are one of the most indebted nations in the world, so our creditors can make our life hell.

When I wrote an investment market assessment for The Listener seven months ago I noted that the greatest risks of the credit crunch were:

• the orgy of debt around the world bring down more fine financial institutions than we were expecting;
• people in New Zealand still believing the asset we own oodles of – housing – is somehow immune to market forces; and
• the unravelling of 10 years of gluttony for debt leaving a bruising that takes a couple of years for the private sector to recover from.

I am sorry to say all three of those risks have been realised. We are entering a global recession.

A series of measures has to be taken to prevent this becoming a prolonged global recession, but the immediate step is to prevent a mad global panic run on the banking system. Once, and only once, that is assured, governments and central banks will need to rehabilitate the world banking system to ensure the frenzy of indebtedness — which has allowed economies like New Zealand’s to grow so far beyond their means — never happens again.

Since the mid-1980s when the first crisis in this deregulated financial world hit, central banks have sponsored a series of boom-bust cycles in financial markets. Each successive boom-bust has been scarier than the last, underpinned by central banks‘ benign negligence to control the prudential standards of credit issuers. The result is that what is commonly known in economic circles as the “structural imbalances” — between creditor and debtor nations, between indebted households and flimsily founded lending houses — have just got larger and larger. It is a shameful indictment of central banking, and the price of that incompetence is just beginning to savage the world economy.

But even if central banks and governments have the will and the fortitude to address the underlying cause – their own behaviour – the excesses can only be addressed in an environment of dull but stable economic and financial activity. It can’t be taken on in the environment of panic we have now. So we first have to get rid of that instability.

HOW HAS IT COME TO THIS?

It started with the financial deregulation of the early 1980s. But financial re-regulation is the answer – that would be throwing the baby out with the bathwater and is not the way forward.

The 1987 crash was the first sign that given their head, markets do run to excess — in this case, sharemarket valuations became unrealistically high, and companies took on too much debt. The central bank response to that market correction was to flood the system with liquidity, the excuse being that instability could threaten “another world depression”. In the heat of that moment of official panic, this was the correct response. But it should have been only the precursor to what should have followed: an overhaul of the financial sector operating conditions that allowed loans to corporates to expand as rapidly with little regard to risk.

Here was the first warning from the deregulated market. Yes, deregulation will unleash financial sector “innovation” and “entrepreneurship” that will take us to a more efficient and effective distribution of the scarce capital an economy needs as fuel to grow. But it’s naïve to think that we will arrive at this nirvana immediately and smoothly. It is in the nature of markets to reach this sustainable position only through an imperfect process that has them taking wrong turns at forks in the road and doing U-turns in all manner of cul-de-sacs. It’s a very clumsy way to go, but we know no better economic system.

The inherent volatility of this zig-zagging search and correct market path is something regulators — and particularly politicians — love to think they can eradicate from the capitalist system. But get rid of it they certainly can’t. The relevant question is whether the ultimate stability this market approach promises contains an inherent instability. A “Minsky Moment” — named after US economist Hyman Minsky – is the crisis point a market eventually reaches as a result of swinging too far away from what is sustainable: a major selloff starts because the supply of people prepared to pay the previously high prices has run out. After the necessary soul-searching, asset price collapses and cleansing of the excess, the market then swings back to something more robust – temporarily though — until it sets off again in search of the next point of intolerable fragility. 

And boy have we had our share of global “Minsky Moments” since financial deregulation:

• 1987 sharemarket crash – share valuations were too high given level of corporate indebtedness. A small rise in interest rates triggered the crash.
• 1990 savings and loan crisis – US institutions borrowed short and lent long. As interest rates rose, their depositors moved funds to the money market and these institutions were squeezed into insolvency.
• 1998 Long Term Capital Management crisis – this four-year-old hedge fund grew so large its demise threatened the US financial system. Its major position was a debt-funded holding of government bonds around the world. These values plunged when the Russians defaulted on their bonds; the company was so leveraged its equity capital was annihilated.
• 2000-2002 dotcom bubble bust – the extent of debt-funded bets in financial markets continued to climb exponentially, with the latest fad, technology stocks, receiving some big bets, often resulting in price/equity raios as high as 100+. The raising of interest rates finally led to the market collapse as big-borrowing investors moved to the sidelines.
• 2008 credit crunch – the deterioration in the quality of loans extended has continued since the 2000-2002 meltdown, with the residential property sector in particular having been the latest investor fad. But the shock from higher fuel and food prices combined with the squeeze from rising interest rates caused US householders to start defaulting on mortgage payments, leading to some US institutions there folding. In addition the highly leveraged area of structured finance started to implode under the interest rate pressure.

 WHAT SOLUTIONS WERE APPLIED?

• 1987 sharemarket crash – the US Federal Reserve pumped liquidity into the system rapidly to “save the world”. It failed to follow up once markets stabilised and the  trend to ever higher global leverage began.
• 1990 Savings and Loan crisis – a US taxpayer bailout saved some some institutions, shut others down and led to the merging of others, while ensuring depositors didn’t lose their funds.
• 1998 Long Term Capital Management crisis – a Federal Reserve-organised bailout.
• 2000-2002 dotcom bust – the central banks led the rescue here. In the US, for example, the Federal Reserve cut rates from 6.5 to 1% in order to stem the contagion.
• 2008 credit crunch – Federal Reserve supplied emergency funding and US government nationalised several major banking houses. Rescue missions still required.

THE RISE OF ‘MORAL HAZARD‘

As frightening as the list is, does it follow that something systematic is going on here that the authorities have yet to get their heads around? Absolutely.

The actions of central banks to keep saving the market when it tries to “correct" has led to a steady rise in the degree of risk investors and lenders are prepared to shoulder in pursuit of profits. This “moral hazard”, as it‘s become commonly known, was sponsored particularly by the US Federal Reserve under the tutelage of former chairman Alan Greenspan. It goes like this.

Because increasingly investors have felt that they are no longer fully exposed to the risk of an investment going belly up, that the central bank will reflate the economy either before this happens or before any share-price collapse becomes permanent, they have been prepared to bet more money than they would have otherwise. The sheer weight of such investor money has driven up asset prices.

Further, in such an environment of heightened investor interest, an asymmetry of information is bound to arise, where some in the market know an awful lot more about investor intentions than others. The availability of loose finance, enables those agents in privileged positions to take bets – sometimes against their own clients – and exploit that asymmetry. It’s analogous to real estate agents buying and then on-selling houses to their own clients – not unheard of even in Napier! But this type of activity becomes  common in the fast-moving financial markets.

The pertinent question is: why have the central banks taken an approach that has allowed the amassing of such colossal exposure to risk? Collectively the central banks have blithely overseen a deterioration of prudential constraints on credit lines, enabling even the most staid commercial banks to participate in swashbuckling unregulated markets of structured finance, derivatives and hedge funds.  Simply by moving stuff off their balance sheets – and away from the central banks’ supervision — these banks have been able to play fast and loose in the unregulated sector.

Here’s a typical way it arises. A bank makes a swag of normal loans, limited by the central banks‘ requirement: normally a simple restriction on how much cash it should hold and how much shareholders funds it has to have copmpared with the deposits it takes in. So it can borrow from the public and on-lend, but at all times it must have, say, 15% of its total balance sheet as shareholder equity. In this case, $15million of shareholder funds enable the bank to take in deposits of $85 million and make loans of $100 million.

Enter the age of seciritisation, which has enabled an enormous expansion of bank lending. This enables the bank to bundle together and sell off its loans to other investors for cash, hopefully booking a profit from the sale and boosting its equity in the business. It can then start lending again — even a little more this time.

These securitised bundles of loans get broken up, mixed with other bundles, repackaged and re-rated by the credit rating agencies and enter the market in an altogether new guise. Structured debt securities or hybrids have become so complex in terms of what the underlying risk really is that few promoters of these products even appreciated their toxicity. Who cares? There were plenty of buyers out there willing to trade them. No wonder the market collapsed.

IS US$700B THE FINAL FIX?

The answer is no.  But it provides some breathing space for other policies to be rapidly developed and introduced to stop the rot. There is no sign of these policies yet – which portends more pain. To understand why, consider the typical, albeit greatly simplified, balance sheet of a commercial bank.

 

BANK BALANCE SHEET
Assets	Liabilities
Cash Investments "Trash" Loans	Shareholders‘ Funds Deposits

 

 

A bank takes in deposits from the public and invests those proceeds, mainly in loans but in a range of other financial market securities as well. The central bank requires the bank to maintain a certain ratio of cash on its balance sheet and a certain ratio of shareholders funds.

Since the onset of the sub-prime crisis began, the amount of “trash” on bank balance sheets has been growing. Trash consists of investments gone sour (whizz kid financial market bets), loans that are no longer being serviced (sub-prime), and mortgages whose collateral backing less than the loan because of the housing slump. One of the glaring results of this decade or two of deteriorating bank prudence, is the dramatic rise in the number of mortgages that are "out of the money". Banks with lots of these on their books are actually insolvent.

The US$700 billion “Troubled Asset Relief Programme” (or “Taking Out the Trash”) is a US taxpayer-funded rescue of those banks that already have so much trash on board, that if they were to cash in all their good loans and investments, they would not have enough cash to repay depositors. These banks are already insolvent – their shareholders‘ funds have been wiped out and the situation is just going from bad to worse for depositors. The US government really has no choice – unless they want a wild run on all banks, they simply have to rescue these banks from insolvency.

But now we come to the hard part. The $700 billion rescue gets rid of today’s trash but only today‘s. It does not prevent more and more of the banks’ loans turning to trash tomorrow. Herein lies the problem – until US borrowers stop defaulting on loans, there is no way the deterioration of the balance sheets of US banks has finished. There is nothing in the rescue package to stop house prices falling, to stop businesses failing because of lack of sales, to stop the job losses, and hence to stop more defaults. Until there is, we can expect the 2008 credit crunch crisis to keep lurching on, contaminating the global financial system and economy as it does.

What might we look for as a sign that the slide is over? My guess is that the deterioration of banking sector prudential supervision has been so bad over the last twenty years, the overpricing of assets – property in particular – so grotesque, that we are on the brink of a major transfer of wealth from debtor to creditor countries and we will see huge expansion of budget deficits as the next step in trying to turn the ship around. We will also see internationally coordinated cuts in interest rates, and we may even see accounting changes so banks no longer have to "mark their trash to market" by stating its current value. But for all that, there will still be victims. They will be yesterday’s winners – all those who have borrowed to the hilt and bought assets at unsustainable prices.

THE NEW ZEALAND DIMENSION

Now if you think all this is too far away to be relevant, think again. If you think our property market is having a soft patch and by this time next year will have resumed its "sure to rise" characteristic of the last six years, then you deserve every cent you make.

If the global financial crisis is enough to stop the Chinese, Japanese and Russian economies dead in their tracks, what makes you think New Zealand won’t be affected, and hard? Those three economies are all creditor nations and we are one of the world’s most indebted.

Over the past ten years our households in particular, but also our farmers have been steadily increasing their exposure to debt, helped by a financial sector that long ago eased the terms of mortgage lending to an unprecedented extent. The result has been an orgy of speculation in the property market that has driven property markets to the most giddy of heights – no matter what measure you deploy.

The following graph gives some idea of the excess in the residential market.

Compared to the 30 year trend, real house prices peaked some 45% above what we might consider a sustainable level. Or expressing it in less boffin-esque terms – the average house price used to be twice the graduate‘s salary; nowadays it is eight times that and the median salary today is less than the interest on the average mortgage. Studies by the OECD and the International Monetary Fund have similarly concluded that the most overvalued housing markets in the world are those of Ireland, Spain and New Zealand.

Let’s look at another measure of this excess.

The percentage of income needed to service the mortgage has once again hit the roof. The historical comparison suggests currently New Zealand households are at full stretch in terms of mortgage servicing and there are three ways this can be corrected: household incomes could boom, mortgage interest rates could plunge, or house prices could drop. You choose which is most likely.

 

UNREAL ESTATE

Now with so many New Zealanders over-weighted in this one asset class, the risk has become extreme that the next few years will see a savage adjustment back to normality. There are a couple of ways in which the real estate market might adjust if this global slump just keeps rolling;

1. The banks force the adjustment

Our banks are struggling to raise money. We have seen them try to tap the international market for funds and either fail or be offered funds only at rates that would further diminish their profitability. This is a major change and I don‘t expect it to improve until confidence is restored that these banks have only high quality (asset secured) loans on their balance sheets. Until then, our banks’ creditors – the gnomes of offshore capital markets – will remain very cautious, and exert increasing discipline on the delinquent behaviour that pervades our banking sector.

Over the past few years, New Zealand banks have been up to their elbows raising money from the international market and on-lending it to households. This is what has enabled this gross over-investment in housing shown in the graphs above. As the current fall in house prices continues on this path “back to normal”, it is inevitable that banks will become more concerned about the asset backing of their mortgage loans. It has become de rigueur over the past few years for banks to lend a higher and higher percentage of the value of a house. Indeed even the government got into the act with its “Welcome Home” initiative, wherein it lends the deposit to those who can’t afford to enter this inflated market.

The fashion of the decade has been to ignore the asset backing of a mortgage loan and just look at the customer’s cashflow. This “new era” of banking has been nothing less than a reckless disregard for prudential management, enabled by sloppy Reserve Bank supervision. As the global recession progresses and jobs are lost, obviously the cashflow of households will deteriorate – it’s hard to service a mortgage when you have no income. But if our banks wait until then, they risk getting caught in their own vicious credit crunch. They will quickly find their mortgagee sales will not claw back the 80-110% of house value they have lent on, and their own balance sheet will take the hit.

I don’t expect such stupidity to be allowed to come so soon on top of the negligence that has led our banks to abandon asset backing as a criterion for secured lending. Rather I expect the offshore masters of our banks (whether it be Head Office or the creditors of Zurich) to force a rationalisation along the following lines.

And lest you think that banks cannot change the terms of your mortgage I suggest you read the small print of your own mortgage. They can actually do it tonight if they choose. Just as an example, here’s what a typical mortgage from the BNZ says;

 …..  we can only demand repayment of any amount outstanding or reduce your credit limit if ……

We think that the securities we hold have significantly devalued;
Circumstances exist, which, in our opinion, impact adversely on our ability to continue making the relevant facility to you.

Seems quite a wide-reaching power doesn’t it? In other words they can pass on their troubles to you the mortgage-holder at any time. Maybe you should leave the phone off the hook.

Of course we expect it to begin by tightening terms on new mortgages. It has. But if the world slump keeps going we are not long away from banks calling up even their most loyal of customers.

2. Home buyers take control of the market

This is a buyers’ market now and so sellers and their representatives, real estate agents are on the back foot. Agents are commission salesmen so naturally they want the highest price possible for the property, as that maximises their profit. Sellers also want the highest price, whereas this is absolutely in conflict with the buyer’s objective. That is why in this very inefficient sector – where to transact a house the fee typically is 3%, compared with under 1% for shares or bonds — real estate salespeople have been able to exercise undue market influence.

For instance, in a bull market, common unethical practices of real estate agents include having their mates make false bids in auctions, buying properties and then on-selling them to unsuspecting clients, and running closed tenders to deliberately suppress transparency and capitalise on buyer disadvantage. In New Zealand their industry body has been outstanding in its defence of these tactics to exploit buyers and manipulate market forces.

But in a falling market, property sellers and their agents will find the shoe is on the other foot, and buyers will find opportunities to at last turn the tables. Agents will have to work a little harder to procure sales for their clients and will not worry at all about stitching buyers into contracts for overpriced properties. That is very easy to achieve in a collapsing market and they’d be quite happy to see a buyer catching the falling knife of a weakening price, such is their vested interest. 

But in this market there remain opportunities for buyers to exert their market power.

The approach that has become the norm now in the weakening UK market, is to stare down the seller on the settlement day of contracts. For example, come settlement day, British buyers are commonly demanding a 20% 11th hour reduction in price. The seller is faced with so much pressure from his creditors to sell that a quick and ready transaction is preferred to the additional costs and stress of litigation. Market power has moved so much that sellers are settling on the detrimental terms.

Of course such an ultimatum doesn’t mean that the buyer will necessarily follow through, but the fascinating thing is that the market is so weak that the threat is enough. The deposit is not enough to compensate disappointed sellers, so fearful they’ve become of losing a sale. I expect this practice to emerge in New Zealand, redressing the imbalance that a bull market and and ramping by real estate agents has produced.

As always there is a silver lining. As house prices return to normal, the ability of many New Zealanders to own their own home will return, and the quality of investment will improve as speculation gets replaced by investors seeking an ongoing return from income earned by their assets, as opposed to just buying an asset because its price is expected to be higher next year.

A KEY QUESTION

Although the property market in New Zealand will feel the effect the most, other sectors will also feel the pain of a world recession. World commodity prices will weaken and that hit farmers‘ pockets, and the big leveraged buy-out deals of the corporate world will be off the table for a few years. In terms of knock-on effects, a chastened household will be less willing and able to spend, so jobs are on the line. And so on.

The key question then with this prospect of a global recession of debateable depth, is when and how will the circuit breaker be tripped? For a quick fix the key that needs to be turned must either:

• reignite the insatiable demand of US consumers for more and more stuff; or
• discover other consumers who are willing to spend more of their income rather than save it (Chinese, Japanese, Germans for example)

Otherwise it’s a far duller outlook with asset prices continuing to fall until they reflect a rate of sustainable income that exceeds what we can get in the bank. For New Zealand investment properties, that would mean a rental yield after expenses of 9-11% per annum. They currently yield about 4.5%. The destruction of wealth that realignment requires isn’t worth thinking about.

Hope and pray (if you’re that way inclined) that the US consumer gets back on her horse!