A quick primer on subprime

Here is a very funny link; check it out....

It is all about the banks.....

Over the last few weeks, a question has bugged me. Could the sub prime crisis bring down a major US investment bank? The crisis has already destroyed some 220 small financial institutions. It also forced Bank of America to bail out Countrywide, one of America's largest sub prime lenders. But what about a gorilla? Could it take down one of the big beasts roaming the financial jungle?

There are two badly wounded investment banks out there; Citigroup and Merrill Lynch. Out these two, Merrill looks the most vulnerable. In early January, the bank reported the worst quarter in its history, forcing the bank to write off $16 billion due to sub prime investments.

How much of a financial hit is $16 billion to a bank like Merrill? These days, balance sheets are available with a click of the mouse. Merrill started out in 2007 with assets amounting to $841 billion, and liabilities of $802 billion.

Subtracting assets from liabilities gives the bank's capital, which is the loss-making shock absorber. So long as the bank has a sufficiently large stock of capital, the bank can ride calamitous decisions like investing in sub prime assets. Simple arithmetic tells us that at the end of 2006, Merrill had capital amounting to around $39 billion.

The Merrill website has a couple of further, more interesting numbers for capital. During the first quarter, bank capital increased by around $2 billion, to around $41 billion. By the end of 2007, the bank had owned up to the losses. As a consequence, bank capital fell to $32 billion. In simple terms, sub prime investments burned up around 24 percent of Merrill's capital.

Looked from the perspective of bank capital, these losses are mighty. While subprime has not put the bank in any immediate danger of insolvency, neither is the bank in any shape to absorb any further shocks.

So when Bernanke met with the rest of the FOMC on Monday, he almost certainly had Merrill foremost in his mind. With the stock market crashing on monday, he had a vision of a further financial shock ripping through the banking system, zapping bank capital, much like the sub prime crisis did in 2007. He may be worried about a recession, but he is petrified of a major bank sinking into bankruptcy.

There is only one way he can help; reduce rates. This will allow banks like Merrill to increase their spreads between borrowing and lending money. Over time, bank profitability will improve and gradually bank capital will recover.

However, the rate cut comes at a time when inflationary pressure in the US is at a 17 year high. The CPI is now over 4 percent and will almost certainly rise further. After several years of relentless dollar weakness, import prices are rising.

However, when it comes to choice between Merrill or inflation, the Fed knows what to choose. It will be Merrill every time. This leads us to a profound conclusion. Whatever the Fed may say, monetary policy is there to serve Wall Street.

The impossible triangle

Consider these three headlines; all of them taken from the same edition of the Times:

Mortgage lending hits a new record in 2007
Half a million homeowners miss mortgage payments
Bargain hunters reignite UK housing market

Despite the seeming contradictions in the headlines, taken together the three articles provide an almost complete narrative about today's housing market.

The first article tells us of a bumper year of household debt accumulation "Gross mortgage lending rose to its highest level last year. Figures from the Council of Mortgage Lenders (CML) show that banks lent a total of £362 billion to homeowners last year, up 5 per cent on 2006 and the highest level since records began in 1999."

To be fair, the mood of the article quickly sours when it acknowledges the recent mortgage slowdown: "lending in December was £22.6 billion, down 25 per cent on November and the lowest level in any month since May 2005."

The second article is much more unpleasant; it is about debt despair and desperation. It tells of "almost half a million cash-strapped homeowners" who have "missed a monthly repayment on their mortgage in the past six months." Since there are almost 12 million mortgages in the UK, this means that about 4 percent of borrowers are in deep trouble. Should these repayment difficulties turn into repossessions, then the UK would have financial crisis every bit as bad as the sub-prime crisis over in the US.

So far, the story is clear; too much housing debt pushing far too many households into payment difficulties. But what about the third article? How does that fit into the reality of a rapidly deteriorating property market. Can the housing market really be reigniting?

The third article is about denial. The housing crash may be upon us, but there are still plenty of people ready to drop a quote that distorts reality. The market is not crashing, it is reigniting because "bargain hunters" have appeared to save the day.

It acknowledges that "the average price of a house has fallen for a third month", but despite declining prices "activity is growing as cheap deals draw out buyers ". Miles Shipside, from Rightmove, gleefully informs us: “Some home buyers are now able to find properties that have fallen into their affordability zone, and are bagging what they see as bargains against previous prices."

So there we have it, the three corners of the UK property market triangle; debt accumulation, debtors drowning in debt, and denial that anything is wrong.

Housing affordability - we still have a long way to go

(click on the chart for a larger image)

The UK house price to earnings ratio has actually fallen marginally in the last months of 2007. House prices are now crashing; they are already down almost 5 percent since July 2007. However, prices will need to fall much further before the price to earnings ratio reaches its long term equilibrium level.

The estate agent window mystery

For a long time, estate agent windows were incomprehensible to me. Prices simply did not make any sense. How could a grotty terraced house in North London be worth £500,000? Were city high flyers really spending their bonuses on houses that just one short generation ago were occupied by bus drivers and dinner ladies?

More recently, I believe I have developed a better understanding of the estate agent's window. With the virtual disappearance of first time buyers, the UK property market has become a closed community of speculators, trading with each other.

It works something like this: speculator A lists their overvalued slum at the estate agents. Speculator B buys it with a loan from the high street bank, and the estate agent takes his commission. The solicitor gets his cut arranging the transaction, and the Treasury gets the stamp duty.

A short time later, speculator B lists the same property at a higher price and passes it along to Speculator C. So long as the high street bank is prepared to lend out progressively larger mortgages, the cycle continues, with prices accelerating at every stage.

In Britain today, housing ownership is churning around in a stagnant pool of speculators. Each time a property changes hands, the new owner takes on a larger mortgage than the previous owner. At an aggregate level, the level of housing related debt has exploded. Nevertheless, everyone seems comfortable because property values have remained buoyant.

Occasionally, housing speculators turn to people like me and try to explain this debt accumulation cycle. Rather than talk about shoddy lending practices, they explain that there is a terrible housing shortage that pushing prices ever higher. In fact, there is so much pent up demand for housing that prices can only ever go one way.

There were occasions when these housing speculators gave me some advice - "go on girl, get out there and get on the property ladder". Here, I must admit to the occasional moments of weakness that led to some unpleasant trips into the estate agents office. I even looked at some potential properties. However, it was follow-up visits down to the high street bank that put me off home-ownership. As I looked at the 25 year repayment schedule, I just couldn't see the annual holiday, or the regular night out. All I could see was a lifetime of financial sacrifice.

These conversations with the home owning elite, the estate agents and the high street mortgage brokers gave the rise in house prices a dubious plausibility. After all, how can anyone argue against the iron laws of restricted supply and pent-up demand?

For a long time, I have to confess to being taken in by this line of thinking. However, one day I noticed that my rent had remained remarkably stable, despite the surge in house prices. If rents are not going up, then where is the housing shortage?

With the housing shortage justification blown away by my stagnant rent, I started to look to credit growth for the answer. Sure enough, the data told a very simple story; UK credit growth was smooching around the housing market like a teenage boy with his first girlfriend.

It soon became obvious that this bubble depended on excessive credit growth and debt accumulation. The housing shortage was merely a abili for irresponsible banking. Furthermore, it was also obvious that house prices would continue to rise so long as banks extend ever larger loans. It would stop as soon as the credit tap was turned off.

After ten years, it appears that the UK housing market has finally reached this point. UK banks have severely restricted mortgage growth. Credit growth has jilted the housing market. The separation will be painful.

Today, speculator A can no longer sell her overvalued property to speculator B. The estate agent will not receive their commission, and the solicitor will not arrange the sale. As for the Treasury, it will not be receiving its stamp duty.

Speculator A, however, will be carrying a very large debt that the high street bank will expect to be serviced. Initially, speculator A will avoid facing up to the harsh truth that their property can not sell at a price sufficient to pay off the mortgage. She will be left with just two choices; either keep paying the mortgage or default. Both will be painful, but the High Street bank would definitely prefer the former rather than latter option. Some speculators will pay, but way too many will end up defaulting.

As for the future, house prices will fall; the bus drivers and dinner ladies will eventually recover those shabby North London terraces. The city highfliers will again buy houses out in Amersham. As for me, I will be able to pass by one of the few remaining estate agents offices without feeling either confused or angry. Yes, better days will soon be upon us. Normal people will again be able to think about buying a home.

Ten facts you need to know about the UK buy to let market

1. As of September 2007, there were 991,000 buy-to-let mortgages outstanding.
2. In 1998, there were just 28,000 BTL mortgages.
3. Again, as of September 2007, the total gross outstanding value of BTL mortgages was £116 billion; an amount equivalent to about 8.5 percent of GDP.
4. In the 12 months up to September 2007, BTL mortgage lending increased by almost £22 billion - an annual growth rate of 17 percent. In terms of additional borrowing, this amount was equivalent to almost 2 percent of GDP.
5. During the same period, the number of outstanding BTL mortgages increased by 27 percent.
6. In 2007, the average value of a BTL mortgage was £117,000. In 1999, it was just £73,000.
7. Northern Rock and Paragon were two of the top five BTL mortgage providers during the first of 2007. At the risk of understatement, both institutions experienced significant financing difficulties during the second half of 2007.
8. Almost a third - 31 percent - of BTL landlords are over 55.
9. Around 41 percent of buy-to-let investors are women.
10. Some 57 percent of BTL landlords are in the business of building assets rather than supplementing income. In other words, it is not about the rent, it is about the capital appreciation.

(Sources: Council of Mortgage Lenders, Citywire)

Government wastes billions on failed IT systems

Nothing exemplifies the intellectual bankruptcy of New Labour than their misplaced faith in new technology. Here is a shocking story from the Guardian about government wasting billions of taxpayers money on failed IT projects.

"The failure of the multimillion-pound police site marks the latest chapter in the government's litany of botched IT projects, with several costly schemes biting the dust. Blunders overseen by Downing Street have included the much-derided £486m computer upgrade at the Child Support Agency (CSA), which collapsed and forced a £1bn claims write-off, and an adult learning programme that was subjected to extensive fraud.

Top of the ministries for wasting public money is the Department for Work and Pensions, which is responsible for squandering more than £1.6bn by abandoning three major schemes — a new benefit card which was based on outdated technology; the upgrade to the CSA's computer which could not handle 1.2m existing claims; and a £140m streamlined benefit payment system that never worked properly."