Krugman’s latest says it all:

Running Out of Bubbles

[A] few pessimists, notably Stephen Roach of Morgan Stanley, argue that we have not yet paid the price for our past excesses.

I’ve never fully accepted that view. But looking at the housing market, I’m starting to reconsider.


Mr. Roach believes that the Fed’s apparent success after 2001 was an illusion, that it simply piled up trouble for the future. I hope he’s wrong.  But the Fed does seem to be running out of bubbles.

As you know, I am even more pessimistic than Krugman on this topic, and I bring up more arguments below.
First, a little bit more from Krugman, who explains that the extremely aggressive policy of the Fed made some sense after the dotcom bubble burst:

[I]nterest rate cuts led to soaring home prices, which led in turn not just to a construction boom but to high consumer spending, because homeowners used mortgage refinancing to go deeper into debt. All of this created jobs to make up for those lost when the stock bubble burst.

Now the question is what can replace the housing bubble.

Nobody thought the economy could rely forever on home buying and refinancing. But the hope was that by the time the housing boom petered out, it would no longer be needed.

That’s Bush’s policies in a nutshell: bet the house and hope that it work out for the best. This is NOT how a country should be run. You do not bet your kids’ future for your temporary enjoyment by basically counting on the “amazing ability of the American economy to grow” while simultaneously gutting everything that made that ability – the middle classes’ productive capacity and the fair price for these. Today, Americans have more money not because they earn more but because cheap debt has made the paper value of their house bigger and financial markets are only too happy to ride that paper value to very real short term profits. Who cares about long term liabilities, right?

That’s why it’s so ominous to see signs that America’s housing market, like the stock market at the end of the last decade, is approaching the final, feverish stages of a speculative bubble.


So what happens if the housing bubble bursts? It will be the same thing all over again, unless the Fed can find something to take its place. And it’s hard to imagine what that might be. After all, the Fed’s ability to manage the economy mainly comes from its ability to create booms and busts in the housing market. If housing enters a post-bubble slump, what’s left?

Mr. Roach believes that the Fed’s apparent success after 2001 was an illusion, that it simply piled up trouble for the future. I hope he’s wrong. But the Fed does seem to be running out of bubbles.

As Krugman points out, even Bubbles Greenspan himself admits that the housing market is frothy:

A slowdown in house price growth was likely and this would in turn mean less of the support for consumer spending seen in recent years.

Even so, the housing market was unlikely to be “a large macroeconomic issue” for the Fed, he told the Economics Club of New York.

Mr Greenspan stressed the large and diversified nature of the US housing market as making a national bubble unlikely, although there was “froth” in the market. An increase in second houses – as vacation homes or investment properties – might be a sign of speculative excess.

The growth of interest-only mortgages and other exotic deals suggested people were having difficulty affording houses and that the market would soon “simmer down”, he said.

Where house prices fell, it was only people who had bought immediately before the turn who might suffer problems. “The presumption there are a lot of bankruptcies out there does not seem credible,” he said.

If you are still not convinced, please go read that SFGate article (kindly pointed out by Twin Planets in my previous diary on the topic:

Two out of three Bay Area home buyers are choosing interest-only loans, and some experts warn that the popularity of the controversial form of mortgage debt is a sign that the overheated housing market is boiling over.

These loans, which allow borrowers to avoid paying any principal for three years or more, have grown explosively in recent years to become the favored mortgage for buyers in the region, replacing the standby 30-year mortgage preferred a generation ago.


housing experts warn that these loans are loaded with risk. Borrowers who put down small or no down payments and who do not elect to pay principal rely almost exclusively on price appreciation to build equity. If home prices flatten or fall, borrowers could end up owing more than the home is worth.

“This is frightening, frankly,” said UC Berkeley economist and real estate expert Ken Rosen. “I’m worried that more and more people are using (homes) as an investment vehicle and not as a consumption market, and that’s true of the peak of housing markets. This is the edgiest we’ve been in the market for a long time. This reminds me of the late 1980s when people were speculating in the market.”

Now, the reason I say that the situation is actually worse than that is that the problems do not concern only the overextended consumer sphere, but they also apply to the financial markets.

Three days ago, Steve Rattner, a very senior banker (and former deputy CEO of Lazard), wrote a very scary opinion piece in the Financial Times:

Hedge funds will have to kick the junk habit

we need to give equal attention to a more basic problem: the vast quantity of old-fashioned imprudent lending that has gone almost unnoticed over the past two years.

Junk bonds have become dramatically junkier.


When the tide goes out, the size of the investment losses may prove staggering. Following record high-yield issuance last year of $147bn (€117bn), there are now nearly $1,000bn of outstanding high-yield bonds. In 1990-1991 and 2002, default rates exceeded 10 per cent. The amount of outstanding paper was lower then, so a high default rate today would be much more costly. Today’s low default rate – only about 1.6 per cent in April, compared with a historic average of around 5 per cent – has lulled high-yield bond buyers into a false sense of security.

There is an old saying: “rising tides lift all boats”. This is precisely what has been happening in the financial world. Easy, extremely cheap money has made it possibler to borrow more at no apparent extra cost, and thus to put more money on the table for asset purchases, fuelling price rises. What is true for houses is also true for financial paper. Rising prices for debt effectively means that remuneration for the risk goes down (interest rates go down), which means that if you are an investor and want better returns, you need to invest in ever riskier stuff.

And that’s what’s happening and what that pices is pointing to: staggering amounts of money have been invested in extremely risky paper – one trillion dollars worth of junk debt, looking apparently safe in a context of cheap money and expensive assets.

Even paper that does not default carries risks for the holders. In 2004, a frothy market squeezed the difference in yield between high yield bonds and US Treasuries down to 3.14 per cent, the lowest ever. Now the market has begun to realise its folly but despite recent interest rate increases by the US Federal Reserve, lots of low quality paper is still trading with single-digit yields – not much of a return for a double-digit chance of a bankruptcy.

IIn their desperate quest for returns, anything that paid a little bit more than Treasuries was purchased, and prices do not reflect the underlying risk anymore.

As I have written previously, and as Mr Rattner also points out in his piece, CDOs and other such exotic instruments are essentially untested in crisis scenarios, and the ripples from the GM and Ford downgrades to “junk” debt status have been pretty worrying. Goldman Sachs has come up with an estimate of 1 billion dollar losses for hedge funds from that episode, and this is widely seen as a conservative estimate. And that was just on the basis of news from two companies (admittedly big borrowers), not macro-economic news like Fed rates or growth prospects.

Other believers take refuge in the strong US economy that has powered corporate profits, which in turn have generated the cash needed to meet debt obligations. But high-yield borrowings often take years to repay and the dicier credits need everything to go right.

AGAIN, that same story: only hope, of wishful thinking, makes these investments look sane in any long term perspective.

timing a big turn in the credit markets is as difficult as predicting the next recession. An economic downturn would certainly trigger trouble, as might a few high profile defaults. Lending to highly leveraged companies would probably dry up, sparking a cascade of defaults.

Under that scenario, our salvation will once again be more liquidity from the Fed. Of late, the Fed has properly been raising rates and fretting about renewed inflation. But Alan Greenspan, chairman, has also said he is unconcerned about the deterioration of credit quality; some sign that he recognises the dangers would be welcome. We should not count on history not repeating itself.

This is the quandary Bubbles Greenspan has put himself in:

  • low interest rates have created asset price inflation, which are a danger in themselves and threaten good ol’ fashioned general inflation (despite China’s downwards pressure on consumer price)
  • the only macro-economic tool that makes sense to fight these excesses is to increase interest rates, as the Fed has finally started to do;
  • these increases threaten to topple the most fragile investments that have been made in the previous period of cheap money, and to trigger a nasty crisis.

Mr Rattner suggests that the Fed should be willing to open the taps again (by lowering rates, presumably), but this is certainly self-serving (he is running an asset management firm, after all), and I don’t see how it can solve the problem – it can only push it a couple of years further, by making it worse than it already is.

But maybe the day of reckoning needs only to be pushed beyond 2008?

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