The deflating U.S./global asset markets are much like Churchills Russia: a riddle wrapped in a mystery, inside an enigma. Who is driving delevering? asks the Financial Times, and the answer comes back, all of us; yet it is hard to see it except in the headlines or to fix it, given a lineup of 6.8 billion suspects. Accustomed to the inevitable credit expansion spawned in the bowels of WWII finance, investors wonder why levered government agencies, banks and hedge funds must sell assets, raise capital or in the extreme, meet the markets grim reaper in bankruptcy court. Aside from cyclical contractions and a brief bout of deflationary monetary policy in the Volkerian 80s, credit has always been available and at a relatively cheap price. Credit and debt finance is, in fact, the mothers milk of capitalism: without it, entrepreneurs may transact, but economic progress would be most difficult with seashells or gold bars for mediums of exchange. And so governments and modern day central banks do their best to provide just enough milk in the form of credit to their economies so that business and employment thrive, while the rancid taste of inflation is disguised.
Yet credit creation modeled after mothers or better yet – cows milk – is not always a predictable event. Almost always the milkmaid or modern-day farmhand is blessed with an ever increasing pail of the white elixir. Occasionally, however, because of irritable bovine bowel syndrome or just bad grass, Old Bessie doesnt produce. So it is in todays financial markets. Debtors in need of more milk are squeezing the teat and not much is coming out. And this deflating supply of credit is in effect the financial markets version of Mad Cow disease. It can be deadly.
While the ultimate explanation rests with a host of factors associated with leverage, financial derivatives, lax regulation, and indeed the sociological willingness of the investment public to take excessive risk in search of diminishing returns, lets just simplistically point – in keeping with our bovine analogy – to the one asset that best typifies all of these fragilities. Lets blame it on the barn, or if you must, home prices. Here is one asset that all observers can agree is going down in price for justifiable reasons. Maybe not Donald Trumps Palm Beach mansion at $95 million big ones – thank you very much – but everybody elses. Theyre going down because quite simply, they went up too much and were financed with excessive debt. The housing bubble was well inflated by low interest rates, easy, and in some cases fraudulent credit, a lack of federal and state regulation, and a gullible public who read the history books for the past half century and knew full well that home prices never, ever go down. Not much of an enigma there. No riddle to be solved it would seem. It was simply a fairy tale too good to be true.
Yet housing, unlike other asset classes, carries with it an aura more like a bad dream than a fairy tale. Unlike the frog that when kissed turns into a handsome prince, housing can morph a froglike economy into something resembling Godzilla. That is because it is the most levered asset class and the one held by more investor citizens than any other. U.S. homes are market valued at over 20 trillion dollars with nearly half of the value supported by mortgage finance of one sort or another. At first blush that appears to be reasonably levered, but at the margin, homes purchased in 2004 and beyond are now at risk of turning upside down – negative equity – and there are some 25 million or so of those. The upsidedownness in many cases results in foreclosures, or outright abandonment and most certainly serves as an example of what not to do for millions of twenty-somethings or new citizens choosing between homeownership and renting. The dominoes fall month-by-month, forcing prices ever lower as shown in Chart 1 provided by Case-Shiller. An asset deflation in turn becomes a debt deflation, as subprimes, alt-As, and finally prime mortgages surrender to the seemingly inevitable tide. PIMCO estimates a total of 5 trillion dollars of mortgage loans are in risky asset categories and that nearly 1 trillion dollars of cumulative losses will finally mark the gravestone of this housing bubble. The problem with writing off 1 trillion dollars from the finance industrys cumulative balance sheet is that if not matched by capital raising, it necessitates a sale of assets, a reduction in lending or both that in turn begins to affect economic growth, creating what Mohamed El-Erian fears as a negative feedback loop.