"The latest PMI data are very, very bad with falls in output, new orders and employment at an extent which would have been unthinkable just one year ago," said economist at Markit Economics Andrew Harker.
The services data mirrors the equally dismal figures from Spain's manufacturing sector which I reported on on Monday, which also hit record lows in November.
With consumer confidence sliding, unemployment soaring and business conditions worsening by the day, expectations continued to be pessimistic with some surveyed going so far as to suggest they thought the economic downturn would last into 2010.
The rather later deterioration of Spain's services sector (when compared with the more longstanding contraction in the industrial sector - see yesterday's post) is also reflected in the quarterly services index published by the INE with the national accounts. Spain's services obviously hung out rather longer than the manufacturing sector, but now this too - in its turn is folding, which means on the provider side we now have all major sectors - industry, services and construction in sharp slowdown. It no longer makes any sense at all to talk about this as a "housing slowdown" - really it never was, since it has always been a financial crisis (or at least since the summer of 2007 it has), with construction just being the first sector to get hit really hard, since without mortgages you can't sell houses, and now we are discovering that without loans you can't sell cars etc, etc.
Accelerating Slowdown After The Summer
Thus while the PMI headline index has now shown business activity among service providers shrinking continuously since last January, the pace of decline has accelerated significantly over the last three months. Both new business and employment contracted at the steepest rate in the series history in November. Companies have now been cutting jobs every month since March.
Also, for those who are following the deflation argument, it is worth noting that service providers cut their charges during the month at the fastest pace recorded by the survey, as the attempted to compete for what is now increasingly scarce new business, while energy costs and other input prices continued to rise, squeezing profits. Meanhwile Joaquim Almunia said today that deflation is not a real risk in the euro zone. Of course, in one sense this can be quite intentional splitting hairs, since while the deflation threat in the whole zone may not be that great (although we do need to wait and see on what happens in Germany here), in countries like Spain and Italy it is becoming an increasingly pressing issue.
Also interesting was the reason why he felt deflation was unlikely:
"We have different conditions than in other countries. We have a labour market that is organised in such a way that makes it extremely, extremely difficult to go towards deflation."
This seems to be saying that we won't be talking about labour market reform as one of the tools in confronting the crisis, and hence, as demand for their products contracts, we will simply sit back with folded arms and let them close, one by one, rather than adopt any kind of aggressive policy to bring back competitiveness. If this is what he has in mind, then this kind of "quietism" is surely a serious error, and anyway (do correct me if I am wrong) but isn't he being paid at this point to promote the Lisbon strategy (labour market reforms and all) as one pillar of our response to the crisis?
Another Shoe To Drop?
My feeling is basically that there is another shoe to drop here. Some of the PMI respondents seemed to accept that Spain's contraction would now almost certainly last on well into 2010, but others continued to express hope that the crisis would prove to be a short-lived one, and expectations for business in 12 month' time bounced back a bit from October's survey low (although we should note that the response remained pessimistic overall). This also seems to mirror a response from Spanish consumers (as covered in my last post) that things would start to get better in the middle of 2009 (my guess is that the really serious part will only be hitting us by then, and maybe not even until later, depending on when builders and property companies go bust big time), but the view is getting support from the insistence by the Spanish government that the Spanish economy should begin to register growth from mid-2009. Joaquim Almunia also reflects this view:
"I hope we will adopt decisions using the fiscal stimulus, using monetary policy ... to avoid a protracted recession and to prepare the economy for a recovery that I hope will come in the next quarters, hopefully in the second part of 2009,"
This view is hopelessly optimistic and superficial, and I do therefore worry about what will in fact happen to business and consumer confidence when it becomes plain that this much hoped for recovery simply isn't going to come. We built the station, but someone unfortunately laid the rail tracks to pass through another town.
First of all, congrats for a very interesting blog.
ReplyDeleteI came across your name through Roubini's website. I found a comment on Spain that was much closer to reality, in my opinion, to what I usually read from foreign macroeconomists.
Anyway, I am very interested in the real estate bubble and its impact on the Spanish financial system. You are obviously very negative, but I was wondering what you think on some specific points:
1/ Solvency. After running some analysis, my current understanding (not very original) is that some of the cajas are going to have serious solvency problems and the government, either directly or indirectly, is going to have to intervene. I don’t think that is going to be the case with neither of the big banks, and I am not so sure with some medium size banks. Question: what is your opinion of the current health of the system?
2/ NPL. Do you have an estimate of the levels of NPL that could be reached?. Figures from BoS in '93 point to an overall maximum of 8.7%, with 4% in household residential. What are, in your opinion the main differences, for good or bad, of the current crises and that of '93?
3/ MBS. I might be wrong but I believe in one of your articles you sounded very cynical on the quality of the Spanish paper. Now, it seems there are at least three major differences with the US model i) most securitization was not really so, as for regulatory reasons asset remained in banks books, the alignment of interest originator/investor is not broken ii) the financial techniques used are much simpler, using "standard" cash flow waterfalls as opposed to CDO square and the like, and iii) the asset quality is in general better as in Spain mortgages are full recourse. What is your take?
Best regards, JSM.
Hello JSM,
ReplyDeleteIf I'm not mistaken I knew your father.
And you do ask some difficult questions, so please forgive me if I simply do my best.
"Anyway, I am very interested in the real estate bubble and its impact on the Spanish financial system."
Actually, you may want to put this the other way round, and get interested in the impact of the problems Spain's financial system is having (due to difficulties in financing the current account deficit) on the housing bubble. Since this I think is the way the causal arrow works in this case, and not the other way round.
This, in my opinion is why so many people have had so much difficulty understanding the extent of the problem we have here.
Now this isn't merely being pedantic, but feeds into the whole way of looking at the thing. What I am getting at is that we aren't looking at a simple and straightforward "garden-variety" housing correction here - like the one Spain had in 1992, or the one the UK had in the late 1980s - but something much more serious.
Basically the housing boom had masked the enormous problem Spain had acculumlated in the current account deficit, for the simple reason the funds which were happily flowing in to fuel the boom meant the books balanced easily enough each and every month. But once people became just a little bit nervous about what was happening to that boom, and how sustainable it was, the flow of funds suddenly dried up, just like that, in September 2007, and the size of the hole in the flagship side suddenly became apparent. Since that time the bilge pumps have been busily trying to drain all the water which has been flowing in, but alas without notable success.
So
"Solvency. After running some analysis, my current understanding (not very original) is that some of the cajas are going to have serious solvency problems and the government, either directly or indirectly, is going to have to intervene."
This is clear. They are, and the government are already intervening in all sorts of ways, in reverse auctions to buy paper, or via the ECB lending against dodgy paper facility (all certified investment grade, of course). Half of the 49 billion odd euros which was being lent by the ECB to the Spanish banking system last summer was for cajas etc.
But this is not the point:
"Question: what is your opinion of the current health of the system?"
Absolutely sound and solid as a rock. Surprised? Well you shouldn't be, since as of 11 October 2008 (the Paris meet up), Spain's banks are perfectly sound, since the government will put in whatever it takes to make sure it is sound (including of course buying up "written down" bad debt), and if the issue is too big for the Spanish government (as in the case of - eg Santander - or any other systemic bank) then the EU governments made a collective decision to support any systemic bank, and if they don't honour that promise, well I think at the very least you could say goodbye to the eurosystem the next day, since you will have noticed what happened when Lehman Brothers failed (counterparty risk and all that).
So I think it is misleading to be worrying to much about the Spanish banks as such at this point (personally I would be much more worried about, say, Unicredit in Italy at this particular point, since they are full of toxic debt from eastern Europe, and the Italian government simply has no money, and no credibility to raise it - what with the ratings agencies breathing down their neck and all that and this is why the IMF are being forced to agree to support Latvia without devaluation, which is extremely unwise and I am sure they know it, since if the Baltics, Hungary, Romania, Russia etc are forced to devalue, then the FX loans become unpayable, and Uncredit goes the way of all things that make large crashes in the night - along possibly with half the Austrian banking system, and some of the Swedish and Belgian ones).
Well, Spain and it's banks are not in these straits (yet). So the government can step in and resolve.
And again it isn't to the banking system that you need to look for problems at the moment, it is to the real economy, since the impact of all this shoring up is simply that no new credit is reaching consumers, and little is being bougth which can't either be purchased in cash or with a credit card. Hence the very sharp contraction in the Spanish economy at the moment.
If you wanted to ask me would the cajas be solvent and able to refinance all their expiring cedulas etc without the government, then I would say don't be silly, of course they wouldn't, but this situation isn't going to arise. The issue is: who is going to finance the government? This is a much harder question to answer, especially with all the debt which is going to be issued over the next couple of years, and investors able to be choosy .
The other question is a bit like wanting to buy a chaise longue which has a couple of scratches and arguing with the antiquarian about a discount, when the real problem is that two of the legs are rotten through and through with woodworm.
"NPL. Do you have an estimate of the levels of NPL that could be reached?. Figures from BoS in '93 point to an overall maximum of 8.7%, with 4% in household residential. What are, in your opinion the main differences, for good or bad, of the current crises and that of '93?"
This is a much bigger question than I can answer. On the debts of the property companies and the builders, 250 to 300 billion euros would be a good working number I think, but then there are other chunks of the corporate sector who will also cave in, so it is very, very hard to be precise here. Corporate total debt is about 120% GDP. How much of that will go the road of NPL over the next 5 years is anyone's guess. I certainly don't have the professional expertise to be able to tell you. The main difference from 1992 is that this isn't simply a housing correction. It is a major economic slump, produced by a financial problem, but the slump itself now has the capacity to cause the financial problem in the private sector to become a financial crisis of the state. Really there is very little comparison between now and 1992, except that in both cases house prices fell and people lost their jobs.
"I might be wrong but I believe in one of your articles you sounded very cynical on the quality of the Spanish paper."
Well, I wouldn't say cynical, I would say wary. The quality of the underlying asset, the mortages and the properties that go with them, depends on what happens to the economy and to prices over the next 5 years or so.
Will Spain hit serious deflation next year? This again is no idle question, but if we get a Japan style downward spiral of wages and prices - and I think arguably at this point Spain is the country most likely to follow Japan down the deflation path.
So the question becomes debt deflation, and whether the government can just sit back and watch Spain's young people straddled with a mountain of debt, as their wages fall, or will they need to step in and legislate to write down the capital values of the debt. They are already giving "payment holidays" and the show hasn't started yet. So basically, my guess is that those holding Spanish paper will end up with some kind of haircut.
"the asset quality is in general better as in Spain mortgages are full recourse."
But what does full recourse mean if the home is only worth 50% of the outsdanding mortgage, and if a judge tells you the mortgagee can only afford to pay half of his monthly payment, indeed those who will be long term unemployed and as the unemployment benefits run out (this isn't the UK, there is no systematic social security) will be back by a judge when they say they can't pay anything. So what the hell does "full recourse" mean here. You have access to the payroll, but if the person only earns a pittance, then what use is that? And as I say, I simply don't see the Spanish government allowing all its young people to sweat under a mountain of debt, while they are also being asked to pay the pensions of all those very large cohorts of newly retired old people. Apart from anything else the implications for fertility would be like some form of national hari-kiri.
And to add to it all, what good is repossesion to anyone in a country with a million plus unsold homes. And don't forget the large number of migrants and British holiday home owners who are involved. On neither of these groups is there anything approaching full recourse. In both cases they can just leave the key and walk.
So, I'm sorry, "full recourse", forgive me if at this point I can't stop laughing.
Ok. Please forgive me if I have spoken strongly, but this is a very strong situation.
And it is even stronger since few seem to understand what it is all about. Spain has a Current Account deficit of 10% of GDP, and to get the financial support we need to keep the economy afloat while people refuse to lend to us, we will have to offer a plan to reduce that deficit to zero in (reasonable) finite time. In this sense we live in a new era, and we aren't going back.
At the present time this deficit is dropping slightly as imports collapse, but not as fast as it should be, and in the meantime the government is raising its borrowing needs. We are moving in 2008 from a 2% surplus in January to a 3% deficit in December (ie a shift of 5% of GDP), in 2009 we will move up to at least 5% (and we could even move higher depending on what happens to GDP. I don't want to get into nightmare numbers just now, but Deutsche Bank have just forecast that German GDP could contract by 4% in 2009, and Spain is worse off than Germany).
Then in 2010 we could find ourselves with a CA deficit of around 8% of GDP and a government deficit rising up into the 5% to 7% region. If this does prove to be the case, then I think the financial markets are absolutely going to see red (there are already problems with the eurozone sovereign 10 year bond spreads) and Spain could find itself just where Hungary was in 2006.
A nighmare scenario? Possibly. But this is what I can see at the present time.
First, let me thank you for the time you spent on the answer. It is really appreciated.
ReplyDeleteSo that you understand where I am coming from, let me start by saying that even though I have some academic education in economics, I am not a macroeconomist myself. I am a professional investor, and macroeconomics is a tool for me, but not an aim; in other words, generally speaking I am more interested in what could possibly happen than in what should happen. Having said that, being a Spaniard (and also being a person), and given the severity of the crises and its probable impact on general well being, I am also interested in what the best solutions could be, even though I’d rather not engaged in that discussion, at least for the time being.
The nick I use might give you a hint of my philosophical believes and my skepticism towards government orchestrated “solutions”. Again, let me avoid a discussion on personal freedom and personal responsibility, and even avoid the more prosaic discussion on interventionism altogether. Let me just said that the metaphor you used in one of your articles, I nice one taken from Borges if I remember correctly, maybe is not the most appropriate, as you are assuming that someone can actually do something to solve the mess we are in, even though we might not like such actions. My point is, as you can imagine, that I am not that sure that magic actions exist.
From my practical approach you will understand that whether the origin of the problem is in the financial system, in the real estate sector or in the regulators actions through interest rates policies and the like, the discussion of the causes of the problem, is not what I wanted to focus on. Let me just say that nobody points a gun to a person to sign for a mortgage, nor anybody points a gun to a bank to grow its balance sheet, nor anybody points a gun to a central banker to cut interest rates. People make choices, sometimes very bad ones, and choices have consequences; but again, no more comments here.
Very importantly, regardless of the causes, I agree with you that the scale of the problem is large. I think I also understand the particularities of the problem in Spain, how the country has been growing beyond its means and how the growth has been financed. I believe I am aware of the imbalances and their fragility.
Now, more specifically:
1/ Solvency. I am afraid a solvency problem is not resolved by discounting paper, even discounting tons of paper. A solvency problem, as I understand it very simplistically, is when you go under because you burn your equity through bad investments. So, as I see it, you can either raise more equity or get rid of your bad investments at above their current price (so suddenly they become good ones) -there is a third way, as always in life, which seems to be parking the investments under the carpet through accounting mimics-. So far, not much of this has been done: ECB discounting is just a provision of liquidity, the Spanish fund for asset acquisition is ill-conceived, poorly managed and small for the scale of the problem, and other actions like debt or deposit guarantees address again liquidity issues (I am aware of the latest accounting changes for parking assets, but stressed mark-to-market investments are not the problem in Spain).
I see from your comments that you think the government is able to step in, but the question would be, do you see short term a capital injection? Where? I also understand that the problem does not evaporate and intervention is only a problem transfer from the financial system to the taxpayer; however, if I may, I would like to postpone this second derivative analysis, otherwise I would be lost on the decision tree. I have a simple mind as you may have already noticed.
2/ NPL. I understand that this is anyone’s guess, but what is yours? Leave aside the corporate sector, what is your estimate for the household mortgage sector? It reached 4% last time, now? 10%? 20%?
3/ “…So the question becomes debt deflation, and whether the government can just sit back and watch Spain's young people straddled with a mountain of debt, as their wages fall, or will they need to step in and legislate to write down the capital values of the debt..” very interesting comment, these are big words… is there a precedent in other economies? “…those holding Spanish paper will end up with some kind of haircut…" this sounds to me as a country default, do you really mean that?
Spanish paper quality: as opposed to that of the US one, it seems to me that the Spanish full-recourse is a strong incentive to pay, even when your home equity is negative. I understand that if you have nothing else to lose, full recourse does not mean much, but the important question here is whether that is the base case or only a possibility, whether you envision a country default as a base case. On the other hand, I agree that immigrants could be low quality borrowers, but it seems to me that they are not the bulk of the debt; either one quantifies this specific risk or it could sound like a bit of a demagogic statement.
Also, on MBS, let me stress that the US model was NOT implemented in Spain. There are substantial differences in terms of alignment of interests and structure complexity. It is very important to keep in mind that Spanish securitization is NOT off-balance sheet (regardless of what some analysts say). Also, let me point out that in there is not, as far as I know, any liquidity arbitrage structures such as those that bought mortgage assets and issued short term paper to finance themselves. In other words, the similarity with the US case is on the deterioration of the asset quality, but not on the other very important issues.
I agree on the size of the problem. I agree on difficulty on sorting out the problem, even though I prefer not to focus on this right now. But what I am trying to figure out is the base case scenario. What could happen with the highest probability?
Best, JSM
Hi again JSM,
ReplyDeleteAnd welcome on board.I just read and thoroughly enjoyed your new comment. Since I would like to treat it with the seriousness it merits, and I would like to enjoy (disfrutar de)writing the reply, so please forgive me if I do it over the weekend at my leisure. I am writing up some of my thoughts on the sovereign spread side and short term growth forcast stuff for a post right now (should be up this afternoon).
Have a nice weekend,
Edward
I can barely see the picture in your post. Perhaps a central bankers meeting?
ReplyDeleteAnyway, I read your new post. I am starting to understand why you contribute to Roubini's website... At this point in life, I am not sure of almost anything, I believe I have become a chronic skeptic ..., but If there is something where I have close to full certainty, almost a 100% degree of confidence, is that... nobody is going to invite you guys to cheer up a party...
Nice weekend.
Hello again JSM,
ReplyDeleteSorry for the delay, but with everything that is happening at the moment, I have been very busy. Now I understand your point of view a bit better.
"The nick I use might give you a hint of my philosophical believes and my skepticism towards government orchestrated “solutions”."
Well this I understand. I too am not that enthusiastic for this - if we look at Japan they clearly spent far too much money using far too much cement, and even 15 years after the slump, Aso is still talking about doing the same to some extent.
It is, in general terms, far better to let market mechanisms do the correcting, but there are times - like now - when the force of the correction is so severe that if governments don't step in and do something, then we can have quite a serious problem on our hands.
To give just one example, it simply wouldn't be funny here in Spain to have one million immigrants roaming the streets without money and without work, living from food they can find in rubbish containers. This would be a humanitarian problem on a grand scale. Incidentally, on Manday I met the person in Spain who s responsible for preparing the OECD annual migration report, and he informed me that people are still arriving in quite large numbers (I also met a woman from Andalusia who works for a centre of "agocida" who told me the same story) so this is definitely already different from the US, where the number of border crossings dropped dramatically after the housing slowdown started.
My feeling is that this is basically because in 2007 the developing economies were still booming, and thus there were work opportunities all round. 2009 is going toi be a hard yera for everyone, and many in Senegal, Ecuador and Romania may well decide that it is better to pass the hard times in Spain, where at least there is good education for children and free medicines, than back at home.
Ecuador defaulted on its debt last Friday (although this doesn't seem to have atracted much attention in the Spanish press) and Romania is heading for one of the worst economic crises in its history next year (worse than Spain, due to the underlying poverty of the country).
So I do think we need some sort of government plan. But this is where we hit the snag, since the government here seems much more geared up to help the insiders (construction companies and property developers, workers on long term contracts) than to make the necessary changes to create a better future for Spain. I mean, my complaint isn't that money is being spent, it is how the money is being spent.
Basically I think there is a big danger in these circumstances that a lot of avtivity moves back into the informal economy. This will severely reduce revenue for the government, but offer work to those migrants who are happy to be 500 euristes, rather than the Spanish - who at the present time only accept being mil-euristes.
YThis is where the general macro argument about deflation and the need to export becomes so important. I have no doubt about it, prices and salaries are about to come sharply doewn in Spain - since there is no currency to devalue this is the only way to correct and start to export. Since most workers are locked-into contracts which have little downward flexibility, this means that the river (of jobs) is going to be diverted round them.
Thus what we could see are growing numbers of Spanish unemployed piling up at the offices of INEM while immigrants continue to arrive in "pateras" and on airplanes and coaches from the East to fill the new positions which become available.
Few seem to be thinking about this possibility, but this is what knowing a little economics makes it possible to see I think.
Solow once said "I see computers everywhere, except in the productivity numbers".
I would say "I see Spaniards everywhere, except in the menial jobs, and in direct contact with the public". Obviously this is an exaggeration, but it is a basic impression you can get riding the metro, drinking coffee, and shopping here in Barcelona at the present time. At the competitive cutting edge of the Spanish economy Spaniards are pricing themselves out of jobs.
More later.
"-there is a third way, as always in life, which seems to be parking the investments under the carpet through accounting mimics-."
ReplyDeleteOK. But look, this is just where the whole question of macroeconomics comes in, since what you need to do when you "park" assets is have some idea of the future path - over say ten or twenty years of the value of those assets.
At the present time many people take the view that property and land prices in Spain will fall, and then recover over a 3-5 year horizon. But what if this deosn't happen? I can think of good macro reasons - especially to do with population ageing - why they may not.
I think it is worth bearing in mind that land prices in Japan haven't shifted from the low they hit in 1994 (and they are just about to enter another very severe bout of deflation) while in Germany property prices generally haven't recovered after the 1995 fall. Quite frankly I don't see why Spain should be any different here. So what I see is quite a sharp fall - maybe 50% - between now and 2011, and then prices staying around that level from here to 2020 (to say something). If you think you can still buy discounted assets now and make it worth your while parking them under such conditions, then go ahead is all I can say (the Japanese government still have a lot of land which it seems unlikely to be ever built on "parked" on their citizens behalf). I may be right, and I may be wrong, and, of course, investors are paid for taking risks, but to take such risks without a good understanding of the macro dynamics would seem to be near to foolhardy to me.
Basically, Bernanke's decision yesterday means that those of us who have been arguing that there was a deflationary problem are no longer so far from the mainstream as we were. If Spain falls straight in next year then this will be even more the case. We may well be headed for an epoch of "funny money", and all this will make investment decisions much harder. People were even expecting negative interest on 3m US treasuries this week, ie they were implicitly paying the US government to take care of their money for them.
On the question of "full recourse", maybe you consider what I said (or perhaps the way I said it) to have been rather demogogic. What I mean is that with salaries and property prices coming down, I find it hard to see those who were very highly leveraged after, say, 2005 are really going to be able to pay, and simple having access to a nomina and a data base doesn't mean you can extract payment. I doubt governments will be able to live with this pressure.
Personally, I think Jaime Caruana (the then governor of the BoS) who admitted back in 2005 that property prices may have been (back then) 30% over valued, but that it didn't matter too much, since there would be few defaults since Spanish people don't have a tradition of emigrating to have been not demagogic, but rather excessively cynical. What he should have been doing was control bank lending with much more conditions on mortgages (a really strict 80% LtV rule would have been quite sufficient), and arguing that the government needed a really hefty (4% plus) fiscal surplus to calm the boom. But all that is now history.......
Hello, these are quick notes, so forgive the lack of clarity.
ReplyDelete1/ On government intervention
"...when the force of the correction is so severe that if governments don't step in and do something, then we can have quite a serious problem on our hands"
Many people say that we are in this mess precisely because of central bank actions. So the argument that the gov has to intervene to avoid an even bigger mess does not give me lots of comfort. You are assuming they have some sort of crystal ball, but reality is proving exactly the opposite... so, forgive me for not continuing this route, I have read very brilliant economists arguing for and against countercyclical measures and, as far as I know, there is no general agreement.
I'm against interventionism because 1) it goes against personal freedom and responsibility and 2) in the real world; it does not seem to work.
Your discussion on immigration makes sense, but I don’t really know where it takes us... obviously, we have a big productivity problem and, given that technology is not Spain's main asset, we need to compete in costs. Thus, the pressure on salaries is clear. On the other hand, the welfare state is unsustainable, and the increase in non-productive population can make things even worse. Problem here is that gov spending does not seem to solve the productivity issue... even though it can alleviate short term social unrest.
Needless to say that I don’t like the increase in unemployment and the tragedy it means for many families. However, please do not mix charity with economic solutions. In my opinion, all these fiscal measures are almost useless, except for the humanitarian purpose.
2/ on the accounting measures and gov asset purchases.
Spanish banks’s problem is not in their investments, is in their credit assets. Therefore, avoiding the mark-to-market of some trading investments (MBSs and the like) does not mean much here. It does mean a lot if you have been buying toxic assets all these years, but we were exporters of these assets, not importers.
For the same reason, even buying securitized mortgage related assets does not solve any solvency problem in the Spanish system, because these securities were sold to Germans, French and Dutch investors.
Now, if you don’t have a solvency issue because of toxic assets, maybe you want to buy them to provide liquidity, and that is what the asset purchase plan seems to be doing. Now, you don’t go to the secondary market, you buy securitizations from the issuers direct. That is what they are doing. This has very limited effect other saving short term liquidity problems.
On the evolution of property prices, maybe you are right and the discount is 50%. Why not. But this variable affects loss severity more than it affects the default level, particularly if your loan is full recourse. The major driver in default rates seems to be unemployment, as you know; and obviously this is going up very quickly as well, but we had unemployment levels of 20% before... that is why predicting the NPL level is so tricky,
However, and this is where I believe numbers are very important, not all loans are 100% LTV. Moreover, not all loans have been given to people with shady credit quality. I believe such generalizations are very misleading.
On whether more regulation could have avoided these practices... I don’t know... again, regulators do not have a great track record in directing the economy in any sense... I think that banks that took too much risk should go belly up... as simple as that. The problem is the Greenspan put, the moral hazard, and Greenspan was a central banker, not a hedge fund manager (funnily he claimed to be a libertarian, what a paradox)
One thing the governments should do, instead of playing around with all sort of political measures, is to inject tons of liquidity in the system. Otherwise the deflationary spiral is unavoidable…. They should put the printing machines to work non-stop and buy all sorts of treasury securities and high quality paper until money velocity and the whole credit channel is repaired… then step on the brakes again and take the money out. I don’t have time to elaborate on this...
Regards.
Hi again JSM, keep checking since I will coem and go with some comments as time permits.
ReplyDeleteAt the present time I am trying to write something on quantitative easing, and trying to decide how mouch Bernanke has learned from the Japanese, and how much the Japanese have learned from Bernanke.
This is the key speech I think where Bernanke indicates why he now favours QE rather than taking the rate all the way to zero. And this is a very interesting earlier critique of what the Japanese had been doing, which may well have had a formative influence on the Japanese in going for QE. And of course now Bernanke is buying commercial paper, and the BoJ are thinking of following.
But for our present purposes I thought you might find the quote and example below interesting, since this is what can happen in Spain. I mean Spain seems set to be a version of Japan 1992 - 1998 plus. Plus, since Spain has a CA deficit while Japan had the ability to export mightily to fall back on, and Japan had a comparatively favourable external environment to work with, while Spain may have a rather disastrous one.
To take an admittedly extreme case, suppose that the borrower’s loan was still outstanding in 1999 , and that at loan initiation he had expected a 2.5% annual rate of increase in the GDP deflator and a 5% annual rate of increase in land prices. Then by 1999 the real value of his principal obligation would be 22% higher, and the real value of his collateral some 42% lower, then he anticipated when he took out the loan. These adverse balance-sheet effects would certainly impede the borrower’s access to new credit and hence his ability to consume or make new investments. The lender, faced with a non-performing loan and the associated loss in financial capital, might also find her ability to make new loans to be adversely affected. This example illustrates why one might want to consider indicators other than the current real interest rate—-for example, the cumulative gap between the actual and the expected price level—-in assessing the effects of monetary policy. It also illustrates why zero inflation or mild deflation is potentially more dangerous in the modern environment than it was, say, in the classical gold standard era. The modern economy makes much heavier use of credit, especially longer term. And note that this rate was still 4.90% at the end of 1994. 13 credit, than the economies of the nineteenth century. Further, unlike the earlier period, rising prices are the norm and are reflected in nominal-interest-rate setting to a much greater degree. Although deflation was often associated with weak business conditions in the nineteenth century, the evidence favors the view that deflation or even zero inflation is far more dangerous today than it was a hundred years ago.
Incidentally, this quote which I just read in the Bernanke paper is just incredible, since it suggests that despite being the spiritual "monetarist" heir to Milton Friedman, he is in fact a Keynesian where it really matters:
ReplyDeleteOverall, my claim has two parts: First, that—- despite the apparent liquidity trap—-monetary policymakers retain the power to increase nominal aggregate demand and the price level. Second, that increased nominal spending and rising prices will lead to increases in real economic activity.
Basically the claim that "increased nominal spending and rising prices will lead to increases in real economic activity" is what Keynes was arguing against his critics. It doesn't matter if the fiscal spending goes to buy shares in banks rather than paying the unemployed to dig holes in the ground, as long as the central bank then buys (unsterilised) government bonds this is Keynesianism, I mean you are simply keeping bank workers rather than car workers employed (leaving aside obviously that banks have a more strategic role in a modern economy than cars, but banks move money, while cars move petrol) the issue is whether government intervention can change the course of real GDP over time (Keynes claimed it could, and his critics claimed it coundn't, and it was better to let the full force of creative destruction sort things out. You seem to be arguing the latter view, but then you say this:
"One thing the governments should do, instead of playing around with all sort of political measures, is to inject tons of liquidity in the system."
Which is justifiable (on what I understand to be your criteria) if the real GDP path is impoved (ie more resources are generated than would have been by not doing this over the longer term), but as I say it is a very strong form of inteventionism, and especially if you buy commercial paper to boot, since this sems to imply that what are basically "functionarios" in the central bank know better than the market and market participants. Over to you :)
"On whether more regulation could have avoided these practices... I don’t know... again, regulators do not have a great track record in directing the economy in any sense..."
ReplyDeleteWell, I guess you are getting a very short sharp shock lesson in macroeconomics here.
Basically there are two ways to regulate an economy, either by using fiscal or by using monetary policy. Traditionally US economists (following the influence of Friedman) have favoured monetary policy, whereas UK economists (following Keynes) have favoured fiscal policy, since monetary policy only operates through indirect channels while fiscal policy influences aggregate demand directly.
Now, as I say, the two get confused when Bernanke starts expanding the cb balance sheet, since if they buy government debt which has been used to finance real economic activity (like guaranteeing commercial paper) the whole dividing line is blurred.
Also, and this is VERY IMPORTANT, fiscal policy becomes critical when you effectively have no independent monetary policy, as is the case in a currency union. So the big flaw in the way the Euro has been operated is that the stability and growth pact, which was the only real economic management tool with any degree of sensitivity, given that interest rates were seldom changed, was allowed to become a joke.
So I do think that had there been a clear fiscal and regulatory environment the huge Spanish boom bust would not have happened, or at least we might have had a boom, but not a massive bubble, and this does matter to me.
If you doubt what impact a regulatory change can have, take a look at the household credit growth chart about two thirds of the way down this post on Latvia. Basically, since the Lat is pegged to the euro Latvia had no independent monetary policy to speak of, so they had a huge bubble. But as soon the cb tightened the credit regulations (just asking for better documentation) and enforced 80% LtVs, the bubble burst, and the whole thing collapsed. Now I am not advocating pricking bubbles, I am suggesting we use a combination of counter cyclical monetary policy and well enforced income documentation and LtV regulations (like seems to have been the case in France) to try and avoid them.
"However, and this is where I believe numbers are very important, not all loans are 100% LTV. Moreover, not all loans have been given to people with shady credit quality. I believe such generalizations are very misleading."
I agree. But I do think we need to focus on key groups, like young people in the 28 to 35 age range. I think a very large number of people in this group who took out mortgages between 2005 and 2008 had very high LtVs, often OVER 100%. This is certainly obvious to me from talking to young people here in Barcelona. The question is, when you have a couple, and all the income of one of them goes paying the mortgage, what happens when the other is employed, or even more to the point, what happens when the other is unemployed for more than one year and the INEM money runs out. People were asking this question for some time before the thing burst.
You don't need shady credit ratings, it is jsut a question of whether you have enough headroom to take up the slack when you hit a worst case scenario. If you don't the loan should not have been made.
Everything now depends on how far back in time prices go, to 2005, to 2002, or to 1998. When we know this, and the level of unemployment then we will know how high the short term NPL rate can go, and when we know this we will know whether the thing will burst or not, but even the fact that we are having to ask this question means we are in a very bad place, and unfortunately I am not optimistic. When did you say that party was being held?
"Spanish banks’s problem is not in their investments, is in their credit assets. Therefore, avoiding the mark-to-market of some trading investments (MBSs and the like) does not mean much here. It does mean a lot if you have been buying toxic assets all these years, but we were exporters of these assets, not importers."
ReplyDeleteWell there are several points here. Of course you are right about toxicity. Maybe you think I am being demagogic here, but I do think the only really "toxic" assets we are likely to have in Spain are "Bonos de Tresuro" at some point in the future, but as you say, even if the cbs as a group decide to offload these as an acceptable asset at some point, this doesn't don't produce meltdown in the same way as the sub-prime did, since the multipliers are different.
But this is all beside the point.
The issue with the Spanish RMBSs in all their different varieties is the mis-match in the terms, between the 5 to 7 year term of the security, and the 20 to 20 year term of the mortgage it is financing. This is why the fact that the wholesale markets are closed to Spanish securities is so important. Between now and 2012 maybe 300 billion euros need refinancing????
"For the same reason, even buying securitized mortgage related assets does not solve any solvency problem in the Spanish system, because these securities were sold to Germans, French and Dutch investors."
Exactly. And this is where the current account deficit comes in, since the inflow from these investors was paying for the petrol etc, and now the flow has reversed. This is a classic third world economy type problem. The problem is a double one, since you have both to refinance the outflow, and find new funding to cover the new monthly deficits going forward. Short term Bonos de Tresuro can do some of this, but they are going to have to pay a premium to attract increasingly sceptical investors.
"Now, if you don’t have a solvency issue because of toxic assets, maybe you want to buy them to provide liquidity, and that is what the asset purchase plan seems to be doing."
Right. But all of this only makes sense if you now sell the government bonds to those Germans, French and Dutch who just pulled their money out, ie if you can convince them that the Spanish government is safer than the Spanish banks, since if you simply sell them to Spanish citizens who take their money out of time deposits, then you are simply going round and round in (ever diminishing) circles.
Let me start by the last point.
ReplyDeleteI sort of understand from your explanations that your believe Spain has a serious risk of sovereign default… if that is the case, that would obviously be an economic Armageddon for the country, well beyond problems with MBSs, I agree that multipliers would be different, but for the worse.
Refinancing. It is certainly the case that the Spanish financial system has important refinancing issues, but I don't believe this is our biggest problem. Firstly, I understand that in the MBS group you are including both asset securitization (RMBS and other ABS) and covered bonds (Cédulas and securitization of cédulas). RMBS in Spain do not have refinancing problems, as they are a simple a repackage of claims over mortgage cashflows, sold to maturity, with no liquidity arbitrage; RMBSs are around 150bn of external financing for the system (I believe the total residential credit book is around 600bn). Cédulas are a different animal because they are a liability of the bank, they are just covered bonds (cédulas are around 150bn plus CDOs of cédulas other 150bn). In theory you could issue cédulas with any term you wanted, from very short term to very long term, just as any other bond you sell. It is irrelevant that they have an additional level of protection linked to the mortgage book. In other words, as a bank, it is not cédulas maturity what you need to be worried about, but the whole duration of your liabilities, from tier 1 to senior unsecured debt, including deposits. Now, the whole banking system always operates with a maturity mismatch, regardless of whether the financing comes from external sources or from national saving; it is simply the nature of the business: borrow short, lend long and take advantage of the yield curve steepness (if there is).
The main problem that banks face is not that of finding basic financing, as they can basically discount the paper either at the ECB or in the new gov facility (certainly you become a more risky business as you increase the maturity mismatch, but you can survive). But that is not the issue, I believe, the major problem is twofold 1) without external (cheap) financing you have to stop growing, so you close down the credit channel, the multiplier evaporate, and the economy suffers, and 2) with the economic deterioration, your asset quality is impaired, as NPL rise, your bottom line is hit and you can simply go out of business. So, my point is, financing is not a (direct) problem for the health of the financial system, short term losses are, and medium term growth is. That is why I focus on trying to estimate the potential level of defaults.
I understand the point on the CA deficit, where I sort of disagree is in going from a general problem to a problem with the banks, assuming they are the whole system, and in my view, they are part of the system and a channel, but not the whole.
So, what do we do with the CA problem? If you are a bit cynical, you basically do nothing, as it is going to take care of itself as the country implodes. My point here is that a CA deficit perse is not the evil, the issue is what you do with the money that you borrow. If you make sensible investments, the CA deficit could be great, as any other debt financing. However, if you spend it in consumption and in useless bricks (the equivalent of having a big party)… you have to deal with the consequences. So, the private sector has a big external debt that has to pay back… and you only pay back producing. And that is why productivity is so important.
To sum up, my view is that we have two main issues: 1) productivity and 2) level of debt (now in the private sector, but in the near future in both private and public sector).
CA deficit, liquidity, maturity mismatches and even bank solvency problems… are very important, but not the heart of the mess.
Just again quickly,
ReplyDelete"My point here is that a CA deficit per-se is not the evil, the issue is what you do with the money that you borrow."
We definitely agree here, although running a CA deficit for FDI purposes is more a characteristic of a devloping economy - which in theory Spain no longer is. Basically in a developed economy the two should more or less balance, FDI in and FDI out, since otherwise you get structural problems in the CA with the income account, and rising negative income flows, which is what Spain, Greece and Portugal (but not Italy) have. This is the heart of the New Trade Theory developed in the 1980s for which Krugman recently got a nobel.
This is why in a developed economy a small (in the 3% to 5% GDP range)over a short time horizon is quite acceptable as a temporary phenomenon (this is what Bretton Woods is all about), but it should not become inbuilt, and I think policy makers in the US now (finally) see this quite clearly, this is why even the US correction will be a comparatively long (ie no recovery in 2009) and paiful one in modern terms, of course what Germany and Japan do in the meantime is anyone's guess.
"RMBS in Spain do not have refinancing problems, as they are a simple a repackage of claims over mortgage cashflows, sold to maturity, with no liquidity arbitrage;"
ReplyDeleteA question here really, since you obviously have much more knowledge about all of this than I do - I am basically a macro economist, and I have had to brush up on all this sort of stuff on my own account, but aren't there various varieties of RMBSs out there, and don't some of them represent some sort of "structured finance" - I'm thinking about things like Santander's Hipotecario 4, and Caja Madrid's RMBS III FTA, which I have seen reference to in the press. Doesn't the originating bank have a liquidity support position in the event of credit downgrades? I thought the whole point was that these things were not entirely off balance sheet (that was thought by someone or other to be good, becuase it might be less risk prone), but the downside of it being on balance sheet is that you can't simply watch it melt down, you have to keep supporting, or am I wrong here?
Also, on the cedulas, I have a question and I don't know whether you have the answer. It relates to "full recourse". As I understood it, one of the strong selling points of the investors about the cedulas was that they were not based on a tranche of mortages, but gave access to the full morgage pool of the issuing banks. Now suppose a group of regional cajas goes bump. do the holders of the cedulas have first claim on the underlying asset, even before deposit holders? I gather the Spanish law was changed at some point here, so I am still not sure how this is.
But, to be blunt. We know London based vulture funds are busy buying up Spanish debt. If these people were holding relevant cedulas at the appropriate moment, and the worst came to the worst, could we see these funds having recourse to Spanish homes, and people flats being sold "over the occupants heads" as it were, for whatever price covered the funds outgoings plus expenses?
Well I think we now have a fair enough idea of what each other thinks, so I will just pick up a couple of points.
ReplyDelete"I sort of understand from your explanations that your believe Spain has a serious risk of sovereign default…"
No. I don't think this. I think that Spain is at serious risk of having significant problems financing its sovereign debt (ie the yield spread widening considerably), and that this is going to condition the whole Spanish response to the problem at some point.
Basically I think we atre good for 2 years - till 2011 - then we could well hit a Hungary 2006 situation (assuming the CA deficit hasn't dropped to near zero at that point, which I doubt looking at the amount of deficit financing the government is thinking of taking on board), where financial markets are no longer prepared to accept the large fiscal and CA deficits.
A lot of the property developers and construction company loans could finally go bad in 2011, and this is obviously a much larger short term risk to the banking sector than simply individual mortgage holders defaulting, which as you are suggesting is containable over the shorter term.
We are all expecting a serious reduction in real Spanish GDP over the next 2 to 3 years, but if we have price deflation and nominal GDP starts to fall and continues to fall, then we will hit the problems with individual defaults say over a 3 to 5 year horizon. Once the INEM money is up, and once the salaries are down so far that paying the quotas becomes a real headache.
Anyway, back to Hungary. Hungary is in no danger of defaluting on the national debt, the only two EU countries that I think are at risk here are Greece and Spain, and this because in neither case will the political dynamics allow the governments to reduce living standards sufficiently (ie accepting the GDP contractions) to pay down the debt. So defualt may become a real danger, especially since the pensions and health related structural deficits only go up and up after 2012.
The danger to Spain is from contagion from this, and the government having to pay a lot more interest on the debt. The loans which may default in the medium term are private ones, not public ones, and this is the same situation in Hungary, with the investors taking the hit in this case being Austrian and Italian banks, and thus taxpayers (note how Italian debt is thus locked into the East European loop).
"I understand the point on the CA deficit, where I sort of disagree is in going from a general problem to a problem with the banks, assuming they are the whole system, and in my view, they are part of the system and a channel, but not the whole."
Well the thing is this, imagine the banks are a piggy bank (hucha) and my house in Spain, then we have a certain amount coming in and going out every month, and the float I keep in the hucha. But if every month I have more going out than coming in then eventually the hucha goes dry. Now, for many years this problem was masked since Spain was effectively exporting cement, by building houses in Spain and selling them to people externally who bought cedulas , and this kept money in the float.
Of course, we don't have the classic problem of reserves meltdown, since we can borrow money from the ECB, but they do not want to buy the Spanish cement at the ECB, they will simply help to avoid a grand slam while the correction goes on, but they are insisting that there is a correction, and thus the hucha is permanently short of money to pay for cement. In this sense the banks may not be the whole system, but if they don't have the liquidity, then you can't sell either houses or cars, and since everyone outside Spain is convinced that you now have to start selling other things, then you can't expect people to coem running to help.
Another issue is if they are in danger of becoming insolvent. Then there is help, but again only on condition you make the changes, and here it doesn't matter whether you go to the EU or the IMF, you will get the same answer: straighten out your imbalances.
The problem is that the "poderes facticos" in Spain are still not convinced that this has to happen, and this is why I think we will stagger on to till 2011 and then we will hit the real crisis.
"CA deficit, liquidity, maturity mismatches and even bank solvency problems… are very important, but not the heart of the mess."
Well we will have to agree to differ here, since I think correcting the CA deficit is Spain's number one priority, and that means Spaniards need to spend less and save more, and not, as they are being advised by the politicians borrowing and spending even more. This naturally means a contraction in private domestic demand. The government is trying to put of the day of the CA correction by increasing state borrowing, and hence public demand, but as I say at some point this will hit a wall, as the cost of borrowing rises so much that there is little net benefit from extra borrowing.
At that point the CA correction will start (as you say via implosion) and the government will be virtually helpless to soften the blow. This is why I think it is quite frankly stupid to be wasting all the ammunition now.
The only way for for Spain is to export. Normally under these circumstances a sharp devaluation would be the remedy, but Spain has no currency to devalue, and as we are seeing the USs need to correct its own CA deficit is being given priority, and the dollar is devaluing, which means the euro is even up.
Thus the only way to correct is via a sharp and quite painful drop in wages and prices which can get Spanish produce cheap enough to attract foreign investment for greenfield sites, and get exports moving. This is when your productivity would come in, since it is quite impossible to make this sort of price correction via productivity gains in the sort of time horizon we are talking about (here to 2015 say), but if you move into new industrial sectors with higher value added you can get this kind of productivity improvement via inward FDI and new technologies.
Well, that's it for now. I enjoyed our conversation. Have a nice xmas, and now lets move forward and see what happens.
Theory is grey, but life if always green and full of plenty of surprises.
Edward
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ReplyDeleteEdward, thanks for the time spent.
ReplyDeleteI usually don't have much time and my English is rusty, to say the least. This upfront caveat is to excuse myself from a couple of misunderstandings: I don't think I did a good job with my explanations on the macro side, I'll elaborate some other moment. Anyway, I appreciate your comparative with other countries, very interesting as it helps me think out of the box. I am familiar with the US, UK and Eurozone current macroeconomic policies, but much less with other economies; even in the developed world, my historic knowledge is limited. It is very interesting to read from someone that put things in context.
On a much more mundane plane: I am familiar with financial economics and the nuances of financial instruments, just because it is my job, as I mentioned before. Needless to say, that does not make me an expert in the matter, as the evil is in the details, indeed it is. Most of the time, the big picture in this field is a bit misleading.
Structured finance is a good example. Transactions in different jurisdictions share some features, but they differ in some important aspects that are particularly relevant when you are in a tail risk situation.
Structured finance in Spain is very different from that of the US. Firstly, the covered bond market (cédulas) is very small in the US, it is more a German and then Spanish market. Therefore, one have to be careful extrapolating any conclusion. Some other time we can talk about cédulas, but let me postpone the discussion.
Now, asset securitization is even more confusing, because it is a huge market both in the US and in Europe, so misconceptions are much more abundant. A couple of points here: i) Spanish underlying MBS assets are on-balance sheet, because of very conservative accounting rules dictated by the Bank of Spain, so we cannot have a surprise of a vehicle coming back to the bank, because the assets have never been taken off. ii) In Spain there are not liquidity arbitrage vehicles; SPVs issue securities (MBS) to by "credit rights", but these securities issued are long term, there are not refnancing needs as those you could see with American ABCP dependent conduits iii) in Spain there are not CDOs of CDOs (so-called CDO squared structures), neither there is nothing comparable to a subprime market segment: credit pools here are heterogenous with mainly prime and some lower quality mortgages commingled in the same pool. certainly the performance of these pools is going to suffer with the economic crises, but it not the case that they will travel from zero default to 30% default in six months, as it is the case with subprime (prime pools in the US are at 4% default; not everything is subprime and not everybody walks away from his debt even without full recourse, even in the US)
We'll talk some other day, It's late and I'm a bit tired!
Have fun--