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Generational Dynamics Web Log for 10-May-2011
10-May-11 News -- US housing price fall accelerates, while Greece's euro debt crisis widens

Web Log - May, 2011

10-May-11 News -- US housing price fall accelerates, while Greece's euro debt crisis widens

The return of toxic synthetic securities

US housing price fall accelerates, while Greece's euro debt crisis widens

For the last four years, politicians, journalists and analysts have been saying, almost on a daily basis, "housing prices have bottomed out," even though that's mathematically impossible in view of the 7-10 million homes that are in foreclosure or close to foreclosure. These are the same people who, in 2004-7, were saying that there was no housing bubble in the first place.

Zillow home value index, 1996-present

Zillow home value index, 1996-present

In fact, the opposite is happening, according to Zillow. Home values fell three percent in the first quarter of this year, accelerating to the fastest rate since 2008. 28% of homes are now "underwater," compared to just 22% a year ago. This means that the rate of foreclosures is going to INCREASE, not decrease.

Last year's claims that housing prices had "bottomed out" were the result of being propped up in 2009 and early 2010 by federal stimulus programs, such as tax credits worth up to $8,000 for first-time homebuyers, according to Zillow Chief Economist Stan Humphries, in a Bloomberg interview. That program "was stealing demand from the future." Now that the stimulus programs have ended, the housing crash is accelerating again.

The housing bubble grew for 11 years before it popped ( "The global housing bubble began in the mid-1990s."), and by the Law of Mean Reversion, we can expect the housing collapse to continue for a roughly equivalent period of time, continuing through almost all of the current decade.

Euro crisis worsens, as S&P again cuts Greece's credit rating

Standard & Poor's ratings services cut Greece's credit rating by two notches on Monday, and said that further reductions are possible, according to Bloomberg.

According to S&P's John Chambers:

"The downgrade reflects our view of increasing sentiment among Greece’s key euro-zone official creditors to extend the debt payment maturities of their 80 billion euros ($115 billion) of bilateral loans pooled by the European Commission. As part of such an extension, we believe the euro-zone creditor governments would likely seek ‘comparability of treatment’ from commercial creditors in the form of their similarly extending bond and loan maturities."

In other words, the EU governments are all going to have to take a "haircut" (lose a chunk of the principal they invested), and they're going to demand that private investors take the same "haircut." The historical average "haircut" in such situations is 40% recovery, meaning 60% loss of principal. So if you're a private investor, it might not be a good idea to invest in Greek bonds.

Recall that a credit default swap (CDS) is a kind of insurance policy on debt that pays off when the underlying debt defaults. When CDS prices rise, it means that investors are increasingly afraid that the underlying debts will default. Once the market has set a CDS price, it's possible to compute what investors believe is the probability that the insurance policy will have to be paid off.

The following chart shows the computed probability of default for the bonds of several European countries:

Probability of government default for various European countries, based on CDS prices (Globe&Mail)

Probability of government default for various European countries, based on CDS prices (Globe&Mail)

So, investors believe that the probability of default is 72% for Greece, and about 43% each for Ireland and Portugal.

The deteriorating situation comes after a weekend of total farce. On Friday, Spiegel said that there would be a secret meeting of EU finance ministers in Luxembourg to discuss the possibility of Greece leaving the euro currency and reinstating its old drachma currency. EU officials immediately came out and claimed that there would be no meeting, that if there were a meeting it wouldn't be about Greece, if it were about Greece it wouldn't be about Greece defaulting, and that the idea of Greece leaving euroland was not under any consideration.

By Saturday, it turned out that all those claims were complete lies, and that there had been a previously unscheduled meeting in Luxembourg to discuss a Greek default. However, they still insisted that Greece leaving euroland was not under any consideration. As I pointed out, why should we believe that, when everything else was a lie?

On Monday on the BBC, I heard one financial analyst (whose name unfortunately I didn't catch) give a lengthy explanation of the latter option. He said that Greece was using the threat of leaving euroland to gain leverage for better terms from the EU negotiators. In other words, a Greek departure from the euro WAS under consideration, at least by Greece, and so even that last claim was a lie. So every statement by EU politicians on Friday was a flat lie.

The return of toxic synthetic securities

The biggest part of the financial crisis was the collapse in value of tens of trillions of dollars in fraudulent synthetic financial instruments (collateralized debt obligations, or CDOs), backed by residential mortgage loans. When the real estate market began to collapse, so did the banking system. ("Financial Crisis Inquiry hearings provide 'smoking gun' evidence of widespread criminal fraud")

Now JP Morgan and other investment banks are doing it again, creating synthetic securities, but this time they're backed by US junk bonds, rather than residential mortgage loans, according to the Financial Times (Access). The article points out that, separate from the real estate market collapse, there was a collapse of the junk bonds market in the early 2000s, when the dot-com bubble burst.

Investment bankers are saying that "this time it's different," and these new synthetic securities won't cause a crisis like the last ones did.

But an analysis by Yves Smith's Naked Capitalism blog disagrees: "But you can achieve the same nasty outcomes via leverage. In the old collateralized obligation market..., investors would do correlation trades (going long one tranche and short another) and would borrow against the trade to enhance returns. So don’t assume the overall activity is less risky because the instruments aren’t as intrinsically dodgy."

It needs to be pointed out again and again that the same people who perpetrated the widespread fraud seven or eight years ago are still in the same jobs perpetrating the same frauds.

From the point of view of Generational Dynamics, the punishment has not yet been harsh enough, and so generational attitudes and behaviors haven't changed enough, just as an alcoholic doesn't stop drinking until he really hits bottom. That's another reason why we can be certain that the real financial crisis has barely begun. It will take a much larger financial disaster to permanently change the attitudes and behaviors of the current generations, and that will be coming soon.

(Comments: For reader comments, questions and discussion, see the 10-May-11 News -- US housing price fall accelerates, while Greece's euro debt crisis widens thread of the Generational Dynamics forum. Comments may be posted anonymously.) (10-May-2011) Permanent Link
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Generational Dynamics Web Log for 10-May-2011 10-May-11 News -- US housing price fall accelerates, while Greece's euro debt crisis widens

US housing price fall accelerates, while Greece's euro debt crisis widens

Euro crisis worsens, as S&P again cuts Greece's credit rating

The return of toxic synthetic securities

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Generational Dynamics Web Log for 10-May-2011
10-May-11 News -- US housing price fall accelerates, while Greece's euro debt crisis widens