William J. Polley

This market crunch is very different from the 1987 crises and the 1998 LTCM panic.

1987 was almost exclusively a market phenomena that had little to do with the real economy. Although market conditions of tight money and an overvalued market called for a bear market. It was portfolio insurance that caused it to happen in just one day. Portfolio insurance was a new financial engineering product that called for managers to sell into a falling market to reduce their exposure to the market and raise cash. But this was in the very early days of computer driven trades and the programs were not as sophisticated as they have become since 1987. The approach had not been properly stress tested and they had failed to anticipate the impact of many managers selling the same securities under the same conditions. This is why it happened largely in one day – although the market bottom was in mid-December. Moreover, this is why the introduction of circuit breakers
and the increased sophistication of the financial engineers meant that this was a one time event. But it also made it easy for the Fed to stem the panic and prevent it from spreading to other markets and/or the real economy. Once managers learned that the selling was a mechanical computer driven event that had been dealt with they quickly regained confidence. They had confidence that the other side of the trade did not know something they did not know.

LTCM was contained to one firm. It had a massive portfolio of treasury securities that were modestly under water. But if they had been forced to sell them it would have driven market prices down sharply raising yields and more importantly impacting the value of all other portfolios of treasury securities. So this was the Fed’s problem and it resolved it by arranging buyers for the securities in an off market transaction that did not drive down market prices. But the important point is that this was contained to one firm and was not directly related to the real economy.

But this time it is different. The distressed securities are not held by just a handful of firms. They are widely held and no one is sure where they are. Second they are directly tied to the real economy as they have been losing value because individuals throughout the economy are having troubles meeting their mortgage obligations. It is not just a market event as in 1987 and 1998. So by providing liquidity today they may be able to stem the selling for one day. But they are not solving the underlying problem. There are still large volume of poorly priced securities in weak hands that are still generating downward pressure on markets. Moreover, because it is tied to weakness in consumer mortgages the problem is still growing. So providing liquidity as it did in 1987 and 1998 may stem panic selling, it does not solve the basic problem.

Well I am a contrarian on all of it. I took a little detour into the private sector and real estate finance from August 2006 to March 2007 and watched this close up. I am just not at all sure we have the causal arrow pointed in the right direction here.

Late in 2006 there was an uptick in the AMOUNT of mortgage defaults in the mid-West and an uptick in the RATE of mortgage defaults in Southern California and the Sun Belt generally. The unfortunate result was that the SoCal situation, primarily though not totally related to the predictable behavior of speculators at the bend point of a market bubble, got confused with a more structural problem of subprime lending to create a climate of fear all out of proportion to the realities.

In a lot of cases the math is swamping the economics here, fundamental differences between equities and housing are being ignored. If you own a stock and it is underperforming or even declining you really only have one option: you sell it for what the market will yield that day, that is you can't just walk away without taking a dead loss. Housing is WAY different. If you manage to get into a 100%LTV (Loan to Value) position, (and in 2005 who couldn't?) you have two logical options depending on where you are on the price curve. Now it costs money to sell a house, you are not only talking a 6% commission (in my state) but additional costs that might take the entire transactional cost to maybe 8%. Now anyone whose equity position is in excess of that transactional cost is going to sell, in real estate nobody walks away from equity. But your logical course of behavior changes sharply at that bend point, the instant your equity position is negative then walking away from the transaction entirely starts making financial sense. On a 100% LTV interest only loan on a house bought too close to the top of the market after discounting for rent and the hit to your credit score going forward, default starts looking like the right and maybe the only possible choice, particularly if refinancing avenues have been shut down.

The problem is that too much of the reporting is expressing this change in percentage terms instead of absolute terms. Well percentages are always going to get you in trouble when there is a rapid transition between logical actions on one side of the curve and actions on the other side of the bendpoint. That is telling us foreclosures are up 700% year over year may not tell us anything of substance at all, if the market was such that you could extract any equity and salvage your credit score in June 2006, then of course you sold, the rate of foreclosures in a rising market should approach zero. On the other hand in any market where price lags the combined cost of the mortgage balance and transactional costs to sell, then an action that made no sense at all a year back, i.e. default, becomes a possible solution. And if the difference is expressed in percentage terms it will be freakishly high. And the change can be shockingly quick.

Certainly the bubble was a reality, more pronounced in some places than others, but the fact is that in 8 of 20 metropolitan markets prices are up over a year ago even now. And if you extended that back three or four years then you would find relatively few people under water at all. Harsh as it may seem if you got into the housing market in certain metropolitan areas after June 2005 in the face of all the bubble reporting going on even then, well sorry for your loss, I hope the cheap rent made up for it.

If I had to sum up the situation it would be that certain end investors woke up to the fact that certain speculators were playing them for chumps. The speculators were buying houses using investors money with rates and terms they had no intention of actually paying, that nice, juicy reset rate was never going to happen, not when the speculator could sell out of a positive equity position (the prepayment penalty just being another transaction cost) or walk away from a negative one.

Certain of these loans were almost guaranteed to underperform and so take down the packaged securities that contained them. Wall Street simply got greedy and woke up too late to the reality that they were the folk getting fleeced. In my view they overreacted, they stampeded away from a sector that on balance was not performing that badly, and in doing so actually exacerbated the situation by shutting off refinancing options, but then again what do you expect from sheep.