On January 21st, Lloyd Blankfein left a peculiar voicemail message on the work phones of his employees at Goldman Sachs. Fast becoming America’s pre-eminent Marvel Comics supervillain, the CEO used the call to deploy his secret weapon: a pair of giant, nuclear-powered testicles. In his message, Blankfein addressed his plan to pay out gigantic year-end bonuses amid widespread controversy over Goldman’s role in precipitating the global financial crisis.
The bank had already set aside a tidy $16.2 billion for salaries and bonuses — meaning that Goldman employees were each set to take home an average of $498,246, a number roughly commensurate with what they received during the bubble years. Still, the troops were worried: There were rumors that Dr. Ballsachs, bowing to political pressure, might be forced to scale the number back. After all, the country was broke, 14.8 million Americans were stranded on the unemployment line, and Barack Obama and the Democrats were trying to recover the populist high ground after their bitch-whipping in Massachusetts by calling for a “bailout tax” on banks. Maybe this wasn’t the right time for Goldman to be throwing its annual Roman bonus orgy. …
PIMCO’s Gomez, co-head emerging markets debt, says there are structural concerns about Europe complicating aid for Greece in the short term, but that the bailout issue will be resolved. In any event, the euro was overvalued and a due for a correction. He also says that ultimately, success will depend on Greece.
This article is a guest post from Tyler Durden, ZeroHedge.com.
Hugh Hendry, always beautifully opinionated, nails it at the Russia 2010 forum with the following oneliner: “Who cares about anyone’s opinion. You pay money for what they do with that opinion.” We are in complete agreement as this conforms precisely with what one of our former legendary, multi-billionaire, corpulent superiors once said “nobody gives a f*&k about your opinion.” On the other hand presenting amusing observations coupled with engrossing narrative, that nobody seems to have an issue with.
The following clip from the Russia Forum pits one against another Marc Faber, Hugh Hendry, Nassim Taleb, PIMCO’s Michael Gomez, Investec’s Michael Power, resulting in a memorable debate. A few blogs caught this clip and posted it yet few actually watched it, as the biggest news from the panel was not Taleb’s admonition that “every single human being should be short treasuries”, an opinion which Hugh Hendry squashes through the groupthink meatgrinder, but Hugh Hendry’s cryptic disclosure that he has uncovered the ABX trade for the next decade, which has “1.5% downside and 75% upside.” Hendry teases, but until the end refuses to disclose what the specific trade is. And while we realize the futility of recreating others’ opinions, here is the money quote from the Scottish contrarian:
“The problem with the bailout of 2008 and the first quarter of 2009, is that it did nothing to eliminate the debt. The debt is just unprecedented in the western world… We’ve had a tripling in leverage for the last 30 years. That tripling in leverage has produced unprecedented gains. The British stock market up 43 times in nominal terms, the S&P up 25 times. This has left many people still hungry for risk. I have a portfolio today… In the UK we have interest rates which are at a 300 year low, since the bank of England was conceived in 1692. I get paid money every day underwriting the risk that the BOE will cut rates further. I use that to cheapen an option which say “I don’t think the Bank of England, and ECB, is going to raise rates in the next 4 months.” And if nothing happens i make 5 times my money. If they raise rates, I lose my premium. My premium is not a lot. I’ll survive that. On the other side of my book, I have discovered something which is close to the Paulson trade in CDOs in US mortgages in 2005 and 2006. Can you believe that a trade with that kind of dynamic exists today. Can you believe if nothing happens and I am just wrong than again I will lose 1.5% but if I am right I will make 75%. That trade exists today and maybe later on I will tell you about it.”
And continuing with opinions, here is the former GSAM and Odey executive on Treasuries:
“I am hugely intellectually bullish on Treasuries. I am long. I fear the end of QE, the money funds are making on the [curve], I am aware of the issuance, I am aware that the States is going to have to sell $2.5 trillion of this stuff. But that’s the marketplace - the marketplace disseminates the bad stuff. I think there is a lesson in Japan. You think they are going to succeed - Mark [Faber] thinks they are going to create inflation. The precedent of Japan suggest that if you allow leverage in your society to breach a certain level, let’s call it 200 or 230% of GDP, then what happens is monetary policy doesn’t work, fiscal policy doesn’t work. They’ve had helicopters, they have distributed free money to their citizens, they have built bridges to nowhere and prices are falling and look set to fall further. My fear just now is that the community of risk is very short treasuries, and is very long risk: risk assets are the hedge against inflation. Now if something untoward happens, the gamma on that trade bankrupts you.”
Elsewhere, you will hear Taleb’s proposed portfolio composition (if you have read Fooled by Randomness or The Black Swan you won’t be surprised), as well as his escalating and very much justified disdain for economists: “if the number of economists from US universities in a country is high, the country risk is high, if the number is low, the risk is low.”
And a whole lot of debate over China, with Hugh Hendry dismantling Jim O’Neill and the other China bulls. “I love Jim O’Neill. I love that Goldman Sachs guy. He says you either get it, or you don’t. I don’t get it. In the future there will be a Confucius saying: the wise man not invest in overcapacity. The flaw of the business model, at the center of it is a craving for power as opposed to profit.” (Kinda funny, coming from a former Goldmanite.) Please watch Hendry’s view on China beginning 55 minutes into the clip.
For those P&L detectives here is Hugh’s most recent missive. Good luck with extracting what the next ABX trade is.
The full hour + debate can be found here. We think far too highly of our readers’ intellectual ability than to point out that the English audio stream would require hitting the Eng button. (Its at the bottom, on the right hand side, and shaded, just to the left of the “Pyc” switch.)
Gold Market
For the week, spot gold closed at $1,130.93 per ounce down $7.32 or 0.64 percent. Gold equities, as measured by the XAU Gold & Silver Index, fell 4.93 percent rise for the week. The U.S. Trade-Weighted Dollar Index slid 0.34 percent. Strengths
Gold Fields Mineral Services has said in its latest gold survey that official central bank sales declined 90 percent in 2009 as they shifted onto the buy-side of the market during the second quarter and have remained there since.
Central bank gold sales for the year were only 157 tonnes, significantly lower than the Central Bank Gold Agreement’s quota of 500 tonnes.
World investment tonnage more than doubled last year, rising by 482 percent to 1,375 tonnes, as investors piled into bullion-backed exchange traded funds and other investment vehicles that track the price of gold.
Weaknesses
China’s decision to raise reserve requirements by 50 basis points for banks hurt commodities and caused gold to erase earlier gains in the week as risk-averse trades strengthened the dollar and Greece’s fiscal crisis dented investor confidence. Analysts see the tightening in China as a weakness because it is believed it will curb demand for raw materials.
Peng Junming, an investment strategist at China’s sovereign wealth fund has said the U.S. dollar has most likely bottomed as there will be very limited space for the dollar to drop further, and has said that there is no urgent need for China to increase gold buying for now because of high prices.
Reports from the U.S. Treasury calculated $15 billion profits from the Capital Purchase Program for banks and another $4.4 billion in profits from other bank investments and lending programs. However, the figures are miniscule when compared to the estimated net losses on its $700 billion bailout program which totaled $68.5 billion for the fiscal year ended in September 2009 primarily due to the continued weakness from AIG, automaker bailouts, and mortgage payment losses.
Opportunities
The World Economic Forum (WEF) has expressed that sovereign credit risks are rising and has said that unsustainable debt levels ranked among the top three risks for the year ahead. WEF has said debt levels have risen from 78 percent in 2007 to 118 percent of GDP in the G-20. Continued weaknesses in Dubai, Greece, and Ukraine may entice investors to seek refuge in gold.
The World Gold Council has said that gold sales across the countries in the Middle East will considerably pick up in 2010 thanks to better market conditions and rising demand for gold as an alternative asset.
Notable gold investor, Rob McEwen believes gold prices may increase to $5,000 an ounce between 2012 and 2014 and maintains his forecast that gold will rise to $2,000 an ounce by the end of the year.
Threats
Governor Schwarzenegger is refusing to consider tax hikes and is relying mostly on $8.5 billion in expenditure cuts from medical insurance programs, among others. He is also counting on the U.S. government contributing nearly $7 billion to plug the budget deficit gap. As a result, Standard & Poor’s cut California’s debt yet again citing “severe fiscal imbalance and the impending recurrence of a cash deficiency if the state’s revenue and spending trajectories continue.”
The chairman of the Commodity Futures Trading Commission said that the agency’s planned meeting in early March to discuss possible position limits on metal futures and options contracts will focus on gold and silver contracts.
Inflation fears in Venezuela have risen after President Hugo Chavez decided to devalue the bolivar by 50 percent to benefit the largest state-owned oil producer after margins fell due to the fall in crude prices last year. It will raise cash for social projects and will increase wages ahead of parliamentary elections in September. Chavez has warned businesses that raise prices ahead of the devaluation will be seized by the government.
This article is a guest contribution by by Tyler Durden of ZeroHedge.com.
As we pointed out two weeks ago, PIMCO has been preparing for 2010 by selling out its legacy “safe” MBS and Treasury holdings, and shifting largely to cash. Furthermore, the recent hirings of corporate and distressed asset managers indicates that the traditionally Treasury heavy asset manager is set to become the world’s biggest fixed income hedge fund, focusing on IG, high yield and distressed investments. As PIMCO is a critical manager in numerous government bailout programs, we can only hope that the firms’ Newport Beach Chinese Walls are better at keeping secrets than the characters in assorted O.C. legacy “reality” shows. The below presentation by PIMCO’s Mark Kiesel indicates why PIMCO will soon be one of the primary actors in future official creditor committees in the upcoming wave of corporate bankruptcies (yes, shockingly assets do have to create cashflows for companies to avoid bankruptcy).
This is an interesting segment from Fox Business aired on Dec. 28, 2009 where John Tabacco from locatestock.com talked about the top five most shorted stocks. The following is a summary of the interview along with some of my thoughts.
The Biggest Shorts - Past & Present
According to locatestock.com, the top short of the decade, and you guessed it, is Lehman Brothers.
But did you know…
Other biggest shorts for the decade include TARP and bailout recipients: Fannie Mae (FNM), Freddie Mac (FRE) and CitiGroup Inc. (C).
Overstock.com (OSTK), at number five, had 140% of its entire outstanding shares shorted at one point of time; giving rise to one very impassioned advocate against naked shorts - Patrick M. Byrne.
Some big players base their short strategy on fundamentals, and sometimes will increase positions over time, or hold their short positions long (more than a year).
The new champion, according to Tabacco, is MSCI Emerging Markets Index Fund (EEM) - the most popular short by volume requested.
Dollar’s Gain Is Commodities Loss
The rising short interest in MSCI Emerging Markets Index Fund (EEM) suggests a continued flight into the perceived safer U.S. market. This trend could further prop up the Dollar, and will likely have a negative impact on commodities, with natural gas probably being the only exception, as the flaming fuel is generally non-dollar reactive.
Dollar & Stocks May Rally Together
However, equities might stand a better chance since the inverse correlation seen between the Dollar and stocks remains broken, as discussed in my article just before Christmas. In fact, this view is reinforced by Dr. Marc Faber, who told Bloomberg yesterday:
“U.S. stocks and the dollar may keep rallying together, reversing a relationship that existed from March to November.”
Faber also said that Dollar may appreciate 5-10% against the euro in the “near term” as bearish betting on the greenback becomes too crowded while equities advance.
The Three Amigos?
Shares of Fannie Mae (FNM) and Freddie Mac (FRE) soared to their highest since October on Monday after the Treasury Dept. signed over the checkbook by removing caps on federal support. Meanwhile, some analysts see Citigroup Inc. (C), with both explicit and implied government support, as ”The Can’t Lose Trade Of 2010.”
So, here is Question of the Day:
Would you buy Fannie, Freddie, Citi, and why?
Hint #1: The pay packages the Treasury announced last Thursday for Fannie and Freddie chief executives consisted exclusively of cash compensation; no shares were offered.
Hint #2: The Treasury Department had to shelve its plans to sell $5 billion of Citigroup Inc. (C) common stock in a public offering just two weeks ago.
Hint #3: CitiGroup, Inc. (C) has boldly gone for a zero valuation allowance since 2006 in its deferred-tax asset; whereas JPMorgan Chase & Co. (JPM) had a $1.3 billion, or 10%, allowance in its $13 billion net deferred-tax asset as of last Dec. 31.
Video Source: YouTube
“Masses are always breeding grounds of psychic epidemics” ~ Carl Jung.
The following is a guest contribution by James MacGee of the Federal Reserve Bank of Cleveland.Mr. MacGee is an associate professor at the University of Western Ontario and a research associate at the Federal Reserve Bank of Cleveland.
by James MacGee
Housing markets in the United States and Canada are similar in many respects, but each has fared quite differently since the onset of the financial crisis. A comparison of the two markets suggests that relaxed lending standards likely played a critical role in the U.S. housing bust.
Despite their many points of similarity, housing markets in the United States and Canada have fared quite differently since the onset of the financial crisis. Unlike the U.S., Canada has not experienced a dramatic increase in mortgage defaults, nor has any Canadian bank required a government bailout. As a result, observers such as The Economist have pointed to Canada as “a country that got things right.”
The different housing market outcomes in Canada and the U.S. can tell us something about the underlying causes of the housing boom and subsequent bust. In particular, they can be used to evaluate the roles that low interest rates and relaxed lending standards played in the boom and bust.
Some observers blame monetary policy for lowering interest rates over 2002–2005, pushing up housing demand, increasing residential investment, and raising housing prices. In this view, the monetary-policy-induced housing boom thus set the stage for an inevitable housing bust.
Others contend that relaxed lending standards, highlighted by the rise in subprime lending, played a critical role. This loosening of standards led to an increase in housing demand, as mortgages were issued to households that were likely to have trouble making the mortgage payments. This extension of credit to risky borrowers helped fuel a housing boom and set the stage for the resulting surge in defaults, which were a big factor in the housing “bust.”
The Canada and U.S. housing market comparison suggests that relaxed lending standards likely played a critical role in the U.S. housing bust. Monetary policy was very similar in both countries from 2000 to 2008, but housing prices rose much faster in the U.S. than in Canada. This suggests that some other factor both drove the more rapid appreciation in U.S. prices and set the stage for the housing bust. A likely candidate is cross-country differences in the structure and regulation of subprime lending markets. That mortgage delinquencies began to climb before the recession in the U.S. but only began to rise recently in Canada (after the economic slowdown began), points to the significance of those structural and regulatory differences in explaining the U.S. housing crash.
Canadian and U.S. Housing Market Trends
Canada and the U.S. experienced significant increases in house prices and residential investment from 2000 to 2006, though prices in Canada appreciated more slowly. Figure 1 plots the S&P/Case-Shiller 20 city composite index and the (Canadian) Teranet-National Bank 6 city composite index. Both series are based on repeat sales, making these series a closer approximation to a “constant-quality” price index of nominal home prices than average house price sales. The Case-Shiller and Teranet series indicate that over 2000–2006, U.S. prices appreciated nearly twice as much as Canadian houses. However, Canadian house prices continued to appreciate until late 2008, and are now nearly 80 percent higher than in 2000.
1. Housing Prices
Sources: S&P/Case-Shiller (20-city) for U.S. house prices and Teranet (6-city) for Canadian.
The counterpart to rapid house price appreciation has been an increase in the ratio of mortgage debt to disposable income. While the comparison is complicated by different definitions of the household sector and debt categories in the Flow of Funds accounts, the trends are similar to those of house prices. Between 2000 and 2006, the ratio of mortgage debt to disposable income in the U.S. increased by roughly 50 percent, jumping from two-thirds to over 100 percent. In Canada, the increase was roughly half as large, with the debt-income ratio moving from 70 to 90 percent.
The potential risks of increased household mortgage debt depend critically upon its distribution across borrowers. To see how the distribution of mortgage debt has changed we examine the distribution of the ratio of the outstanding loan to house value (the LTV) of borrowers. A high LTV implies that a small decline in the house price would leave the owner with negative equity. Negative equity is problematic as it removes the option for a homeowner who is unable to meet their mortgage payments to sell their home to repay the mortgage.
As figure 2 illustrates, Canada has significantly fewer households with LTV ratios above 80 percent than the U.S. Before the housing bust, roughly 21 percent of American households with mortgages had LTV ratios above 80 percent, versus 15 percent of Canadian households. Restricting attention to households with LTV above 90 percent the comparison is even more striking: roughly 12 percent in the U.S. versus just over 6 percent in Canada.
2. Distribution of Mortgages by Loan-to-Value Ratio (percent)
United States
Canada
LTV ratios
1999
2005
2007
2006
0–80
76.48
79.14
78.12
84.79
80–90
10.55
8.98
9.66
8.81
90–100
7.56
6.37
6.93
1.53
100+
5.41
5.51
5.28
4.87
Sources: Bank of Canada Financial System Review December 2007; American Housing Survey. The American Housing Survey reports the ratio of all outstanding mortgages (excluding home equity lines of credit) to the value of the house.
A surprising fact about these LTV ratios is how little the distribution of U.S. mortgages by loan-to-value changed during the housing boom. This is surprising given that the rapid house price appreciation acted to lower the LTV ratios of existing mortgages. Working in the opposite direction were two forces. First, some households undid the effect of higher house prices by extracting equity. Second, the rise in subprime and Alt-A mortgage originations from roughly 1.4 million in 2003 to 3 million in 2005 was accompanied by an increase in the median LTV of new subprime mortgages from 90 percent to 100 percent (as documented in Mayer, Pence, and Sherlund, 2009).
While broadly similar trends were occurring in house prices and mortgage debt in the U.S. and Canada, very different patterns of mortgage delinquencies and defaults were emerging. The best available comparison is for delinquencies on prime mortgages (which account for the bulk of mortgage credit) in the two countries (figure 3). Prior to 2006, delinquencies were comparable in both countries (and were slightly higher in Canada). While delinquencies increased more than four-fold in the U.S. after 2007, as of mid 2009 there has been little sign of an increase in mortgage delinquencies in Canada. A similar story holds in the subprime market. Researchers Mayer, Pence, and Sherlund reported that 8 percent of the U.S. subprime mortgages originated in 2007 had defaulted after 12 months, as opposed to 1.5 percent over 2000–2004. The available Canadian data also features an increase in subprime mortgage delinquencies, but the delinquency rate in 2007 was still under 2 percent, according to the Financial System Review in June 2008.
3. Mortgage Delinquency Rates (90+ days delinquent)
Sources: Mortgage Bankers Association. National Delinquency Survey.
Notes: The delinquency rate is the number of mortgages past due as a percent of the total number of mortgages at the end of the period. The delinquency rate does not include loans in the process of foreclosure.
These different patterns in delinquencies occurred during a period of similar macroeconomic performance. Unemployment rates were stable throughout 2007 and early 2008, at roughly 5 percent in the U.S. and 6 percent in Canada. The timing of the recent deterioration in labor markets has also been similar, with unemployment rates rising to 9.4 percent (U.S.) and 8.6 percent (Canada) by July 2009. What these data reveal is that mortgage delinquencies began to increase in the United States before the rise in unemployment, but in Canada they remained low and only began to increase after the rise in unemployment in 2008. That difference is a key clue to determining what caused the housing bust.
Monetary Policy and the U.S. Housing Bust
The low interest rate policy of the Federal Reserve over 2001–2005 is often cited as a key factor in the U.S. housing bust. The main narrative is that by lowering short-term interest rates, the Federal Reserve pushed down (longer-maturity) mortgage interest rates. This policy increased demand for housing, leading to upward pressure on housing prices, which encouraged builders to ramp up construction of new homes. This led to an “oversupply” of new homes, which triggered the housing bust.
The claim that interest rates were too low over 2001–2005 is motivated by a couple of observations. First, the federal funds rate was low by historical standards: declining from over 6 percent in early 2001 to 1 percent in 2003 and remaining low until 2005 (see figure 4). Second, interest rates over this period were much lower than those predicted by the Taylor rule for monetary policy (which relates the Federal Reserve target rate to inflation and GDP) over 2002 to 2006.
The Bank of Canada also made dramatic reductions in its target interest rate over 2001–2002. One might argue that Canadian monetary policy was not quite as “loose” as that in the U.S. as it maintained a higher overnight rate over 2002 to 2004. But a case can be made that Canadian and American monetary policy were very similar, at least in terms of the housing market. Ahrend, Cournede and Price (2008) estimate deviations from the Taylor rule for Canada and the U.S. over 2001–2006 and find that the cumulative deviations were nearly identical.
4. Central Bank Target Rates
Source: Mortgage Bankers Association. National Delinquency Survey.
In addition, mortgage interest rates—the main direct channel through which monetary policy impacts the housing market—tracked each other closely in the two countries. Unlike the U.S., where the mainstay of the mortgage market is the 30-year fixed mortgage, the most common mortgage product in Canada is a five-year fixed rate mortgage (with a 25-year amortization period). As figure 5 illustrates, the two benchmark mortgage interest rates move closely with one another until after the beginning of the U.S. housing market crisis, when U.S. rates fall significantly below Canadian rates.
5. Benchmark Mortgage Interest Rates
Source: International Monetary Fund,International Financial Statistics, COFER data.
The similarity of the impact of monetary policy and the absence of a housing market bust in Canada suggest that some other factor must have been present in the U.S. to generate the boom and bust. This is not to suggest that “loose” monetary policy did not put upward pressure on housing prices—indeed, both Canada and the U.S. experienced substantial levels of house price appreciation. However, the Canada-U.S comparison suggests that some other factor drove both the more rapid house appreciation and set the groundwork for a U.S. housing bust.
Relaxed Lending Standards: Different Subprime Lending Booms
The other leading explanation of the housing boom and bust relies critically on relaxed lending standards. This story is linked to the dramatic rise in subprime lending and high levels of loan securitization, which some commentators have argued reduced the incentives for mortgage originators to maintain underwriting standards. This is one area where there was a significant difference between the two countries, both in the size and nature of the subprime market and in the fraction of mortgages securitized.
The subprime markets in the U.S. and Canada include households with tarnished credit histories as well as borrowers with difficult-to-document income sources. Subprime lending has grown rapidly in both countries, though the magnitude has been far more striking in the U.S. While subprime mortgages accounted for less than 5 percent of mortgage originations in the U.S. in 1994, a fifth of all mortgages originated between 2004–2006 were subprime, according to data reported by James Barth in 2009.
But while subprime lending also increased in Canada, the subprime market remains much smaller than in the U.S. The most cited estimate is that subprime lenders had a market share of roughly 5 percent in 2006—compared to 22 percent in the U.S. (Mortgage Architects, 2007). Moreover, the Canadian subprime market never expanded significantly into newer products, such as interest-only or negative-amortization mortgages, whose popularity grew rapidly in the U.S. from 2003 to 2006. Instead, the Canadian subprime market mainly offered products popularized in the U.S. during the 1990s, such as longer amortization periods for loans (from 25 to 40 years), and mainly targeted near-prime borrowers.
Securitization has also been less common in Canada than in the United States, with roughly 25 percent of Canadian mortgages securitized in 2007 versus nearly 60 percent in the U.S. The Canadian securitization market has grown rapidly over the past decade, rising from roughly 5 percent of mortgages in 1998 to over 25 percent in 2008. However, in many ways, the Canadian market resembles the early stages of the U.S. mortgage securitization market, as most securitized mortgages in Canada are backed by an explicit government guarantee. This government guarantee requires limits on borrowers’ debt-service ratios and amortization periods, which makes it more difficult for lenders to offer some types of subprime loans.
The different magnitude of the subprime lending boom in the two countries is consistent with differences outlined above between the Canadian and U.S. housing markets over the past 10 years. The rapid growth of the subprime market provided an additional boost to demand in the U.S. that is consistent with the more rapid house price appreciation in the U.S. than in Canada.
The subprime story is also consistent with the different pattern of mortgage delinquencies in Canada and the U.S. In the U.S., mortgage delinquencies for both prime and nonprime mortgages began to rise before the recession began and unemployment rates began to climb. In contrast, mortgage delinquencies in Canada have only recently begun to increase—after unemployment rates started rising and the Canadian and world economies slowed sharply in the fall of 2008.
Finally, the relaxed lending story is consistent with the fact that the U.S. experienced a housing bust over 2007–2009 while Canada did not. While the expansion of subprime lending provided a temporary boost to housing price growth rates, when prices stopped rising, the inability of some borrowers to refinance homes they could not afford led to a spike of delinquencies. The resulting increase in liquidation and foreclosure sales put additional downward pressure on house prices, which in turn pushed more borrowers into default. This “negative feedback” cycle helped push a correction in the housing market into a housing bust.
One possible critique of this argument is that while Canada has not yet experienced a housing bust, it is likely to experience one in the next year. Indeed, a recent Merrill-Lynch-Canada report noted that Canadian house prices over the past decade closely resemble U.S. house prices with a two-year lag (see figure 1). Based on this, they concluded that Canada was also likely to experience a large decline in house prices over the coming year. Canada’s smaller subprime market share and fewer households with high LTV ratios, however, suggest that the country is less likely to see the rapid increase in defaults that helped trigger the bust in U.S. housing prices. So far the incoming data suggest that the Canadian housing market is likely to experience a housing market slowdown rather than a bust.
Why Was the Subprime Market in Canada Smaller?
Given the key role played by the “subprime” market, the question is why the Canadian subprime market was both smaller and levels of securitization were lower than in the U.S. While it is difficult to disentangle the reasons why Canada avoided the subprime boom, some factors can be identified that may have contributed to the differences in the Canadian and U.S. subprime markets.
Perhaps the simplest story is that Canada was “lucky” to be a late adopter of U.S. innovations rather than an innovator in mortgage finance. While the subprime share of the Canadian market was small, it was growing rapidly prior to the onset of the U.S. subprime crisis. In response to the U.S. crisis, some subprime lenders exited the Canadian market due to difficulties in securing funding. In addition, the Canadian government moved in July 2008 to tighten the standards for mortgage insurance required for high LTV loans originated by federally regulated financial institutions. This further limited the ability of Canadian banks to directly offer subprime-type products to borrowers.
There are also several institutional details that played a role. The Canadian market lacks a counterpart to Freddie Mac and Fannie Mae, both of which played a significant role in the growth of securitization in the U.S. In addition, bank capital regulation in Canada treats off-balance sheet vehicles more strictly than the U.S., and the stricter treatment reduces the incentive for Canadian banks to move mortgage loans to off-balance sheet vehicles. Finally, as noted above, the fact that the government-mandated mortgage insurance for high LTV loans issued by Canadian banks effectively made it impossible for banks to offer certain subprime products. This likely slowed the growth of the subprime market in Canada, as nonbank intermediaries had to organically grow origination networks.
A Challenge for Policymakers
The Canada-U.S. comparison suggests the low interest rate policy of the central banks in both countries contributed to the housing boom over 2001–2006 and that a relaxation of lending standards in the U.S. was the critical factor in setting the stage for the housing bust. A caveat worth emphasizing, however, is that the Canada-U.S. comparison tells us little about what would have happened if U.S. monetary policy had been tighter earlier. Tighter monetary policy in the early part of the decade may have helped to limit the subprime boom by slowing the rate of house price appreciation over 2002–2006. The Canada-U.S. comparison does, however, highlight the practical challenge facing policymakers in assessing whether a rapid run-up in asset prices is a bubble or a “sustainable” movement in market prices.
Recommended Reading
“Monetary Policy, Market Excesses and Financial Turmoil”, by Rudiger Ahrend, Boris Cournede, and Robert Price (2008). OECD Economics Department Working Paper No. 597.
The Rise and Fall of the U.S. Mortgage and Credit Markets, by James R. Barth (2009). Milken Press.
“Rebuilding the Banks,” The Economist, May 16, 2009.
“The American Mortgage Market in Historical and International Context,” by Richard Green and Susan Wachter (2005). Journal of Economic Perspective, 19(4), 93–114.
“The Rise in Mortgage Defaults,” by Christopher Mayer, Karen Pence, and Shane Sherlund (2009). Journal of Economic Perspectives, 23(1), 27–50.
“Comparing the Canadian and U.S. Subprime and Alternative Mortgage Markets: Why the U.S. Subprime Fallout Is a U.S.-only Phenomenon,” Mortgage Architects (2007). <http://files.newswire.ca/40/MASubprime.pdf, accessed: June 15, 2009.>
Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, by John B. Taylor (2009). Hoover Institutions Press.
“Structure of the Canadian Housing Market and Finance System,” by Virginia Traclet ( 2005). Background paper prepared for CGFS Working Group on Housing Finance in the Global Financial Market.
“The Tipping Point?” by David D. Wolf and Carolyn Kwan (2008). Merrill Lynch Canada, Economic Commentary.
Barry Ritholtz, author of Bailout Nation and chief executive of investment manager Fusion IQ, delivered the keynote address at the Citywire Fund Selector Forum in Berlin a few days ago. The highlights from his speech are below.
Part one: How the actions of the Federal Reserve changed everything in 2002-2007
Part two: Eight months after Armageddon seemed upon us, the US economy shows signs of life.
Part three: Where next for stock markets?
Source: Barry Ritholtz, Citywire, November 30, 2009.
According to CityWire, he argued that we were in a secular bear market that began in 2000 and has some years to run. “In secular bear markets, the buy-and-hold approach to investing is a ‘disaster’, he says, citing the experience of 1966-82 in which the Dow Jones Industrial Average went through five strong rallies and ended up back where it started. It’s not all bad news - the current cyclical rally has a few months yet to go with up to 20% upside, based on historical patterns - but will be tough going, Ritholtz warns,” reported the website.
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In part two of the interview Ritholtz discusses the state of the US economy, why the US government should have let the banks collapse, and why inflationary fears are misplaced.
Source: Richard Lander, CityWire, November 24, 2009.
With futures deep in the red, let’s take a look at how markets do after big quarters. The quarter ending September 30 saw the Dow putting in its best quarter since 1998, up a solid ~15%.
With everyone waiting for a pullback, and yesterday (Thursday] and today [Friday] viewed as the probable start, perhaps its time to review some history. What has happened historically after markets have put in record setting quarters - 15%+?
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For the most part, momentum has trumped mean reversion historically. Jim Bianco crunched the numbers, and he found that “stocks returned an average of 1.33% over the month following one of these record quarters, 3.46% over the following quarter, and 9.95% over the following year”.
It is worth noting that these average returns following quarters of 15%+ performance are nothing out of the ordinary. The average monthly return over all periods in the DJIA since 1900 is 0.58%, the average quarterly return is 1.66%, and the average yearly return is 6.90%. If anything, the average returns following huge quarterly gains actually outpace the average returns during all periods.
Perhaps another way to look at it is that these record setting rallies, especially following big selloffs, are themselves a form of mean reversion.
You may recall that last time, Mish & I disagreed as to whether this was a recession (Me) or a depression (He). This time, the debate is over the current rally.
Shedlock pens a response - “Rally in 6th Inning or Top of the 12th?” - and discusses the reasons he thinks the market rally should be ending soon: “The flip side of the coin is this market has advanced so far, so fast that if downside momentum does develop, there is nothing but air pockets below. Air pockets are thus a two-way street. If anything, there is far more air below than above.”
That may be. However, none of the various metrics we track suggest the rally is about to run out of gas anytime soon. That doesn’t mean it can’t end to tomorrow, but we would rather play the high probability, rather than low probability outcomes.
Here are the four most important reasons why I think we can have more upside, plus a look at some grim economic realty.
1) Individual investors remain under-invested.
2) Market breadth and momentum are each positive (i.e. supportive of further upside).
3) Sentiment has not yet reached extreme levels.
4) The broader investment community believes - incorrectly in my opinion - that a recovery is upon us, profits are getting better.
5) History shows that secular bear markets have deep selloffs and huge rallies; this current rally still has room to run based upon a composite of prior cycles (see “Four Stages of Secular Bear Markets“).
Now, about that economy. Here is my dirty little secret. FOR TWO THIRDS OF THE TIME, THE ECONOMY REALLY DOES NOT MATTER.
I know that sounds insane, but consider the following: In the middle of secular bull markets, economic info seems to have the greatest correlation with market performance. Good data, more profits, better market action.
At market tops, the economy looks great. Valuations are rich, but record profits support the multiple.
Then it all goes to hell.
At bottoms, it looks awful. It looks like these companies will never make another dime, that layoffs won’t ever end, that we can never escape the tar pit.
And then we do.
This must be perplexing, maddening, infuriating to pure economists. But that is Mr.Market’s job - to frustrate the maximum number of players.
Source: Barry Ritholtz, The Big Picture, September 17, 2009.
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WSJ What's News Late Edition, March 17, 2010by The Wall Street Journal 17 Mar 2010 at 5:56pm
Stocks rise again as the Dow closes at a 2010 high; wholesale prices fall in February, showing inflation remains in check; and MillerCoors shakes things up with a new brew.
Jeffrey Saut Daily Audio Comment Raymond James
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Jeff Saut’s Daily Audio Comment is recorded every weekday, except Wednesday, at 9 a.m. ET. It is made available to the public on this Web page at approximately 1 p.m. ET.
