Bubbles
The year was 1637. The Dutch had captured the spice trade a few decades earlier and had supplanted the Portuguese as masters of the sea. The Netherlands was the most important and powerful nation on earth. The Dutch East India Company was at the height of its influence. This remarkable organization, originally founded around 1600 to support a single expedition, was the first firm to issue stock, the first conglomerate, and the first multi-national corporation.
During this century of change, Dutch scientist Christian Huygens developed wave theory and revolutionized optics, while Antonie van Leeuwenhoek crafted surprisingly advanced lenses and microscopes. Dutch philosopher Baruch Spinoza, a humble lens maker himself in his “day job,” became a leading ethicist and laid the foundation for the Enlightenment a century later. Dutch artists such as Rembrandt, Rubens, and Vermeer gave us new perspectives on the use of light. The country was the economic, technology, and cultural marvel of the world. (Sound familiar?)
In the 1630s, the Dutch merchants returned from the Ottoman Empire with a seemingly innocuous new pleasantry known as tulip bulbs. If properly nurtured in the fertile soil of the area, they would produce unique and beautiful flowers. These bulbs soon became all the rage and set off a buying frenzy. As buyers bid the costs ever higher, it seemed that there was no end to the prospects for profit. At the peak in early 1637, a single bulb commanded a price in excess of that for twelve acres of prize land. But, alas, the bubble burst, and fortunes were lost even faster than they were made. Even the powerful Dutch economy took a while to fully recover.
You would think this whole affair would have taught us once and for all the folly of such speculations. History shows us, however, that nothing could be further from the truth. It is almost 400 years later, and whether it’s precious metals, oil, syndications, dot.com stocks, or home mortgages, we simply can’t resist the temptation to ride these waves.
The past couple of weeks have had the markets reeling. Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley, Goldman Sachs, AIG, and others have all made their moves in various ways. The government is engineering a $700 billion (at least for now) purchase of distressed assets, and markets are working overtime to take it all in and make sense of it.
How did all of this happen over the simple act of expanding home mortgages? What began as a well-intentioned and noble effort to increase the availability of the “American Dream” went terribly wrong. The major culprit was greed, but there is plenty of blame to go around. Governmental agencies and policies enabled and even encouraged loose lending practices. Eager lenders and brokers would originate loans for quick profits. Eager buyers would purchase securities backed by pools of these mortgages, pushing for ever higher yields (and, hence, even poorer underwriting quality). The stock market was suffering in the wake of the corporate accounting scandals, and trillions of dollars were “hot” to find a new place to go. As the economy became ever more global, investors from other nations flocked to these instruments.
The myth underlying part of the resulting problem is that diversification eliminates risk. There are well-established principles by which we can reduce exposure through intelligent spreading of investments, but if an entire portfolio of mortgages is inherently unsustainable due to its very structure, the fact that they are bundled together cannot make them viable.
This particular bubble is bigger than most. The responses will change the very nature of our financial markets (at least temporarily), but they will not eliminate our tendency to speculate. The key to effective policy is to allow markets the freedom to do the things they do well, restrain the unbridled exercise of greed, but not to go so far that we stifle the creativity and innovation necessary to promote economic growth.
We have learned a lot over the years. Without today’s technology and global integration, we couldn’t have created a mess of this magnitude. On the other hand, monetary officials understand from advances in knowledge in recent decades that providing liquidity and the ability to accommodate risk are absolutely essential, no matter how explosive the rhetorical sound bytes to the contrary. Armed with that wisdom, we will come through this situation as a strong and vibrant economy despite the horrific headlines. After all, there are still tulips in the Netherlands.
posted @ 07:57 PM CST [link]
Friday, September 19, 2008
A Double Whammy
Over the weekend, some people along the Gulf Coast and on Wall Street might have wondered if Chicken Little was right—the sky indeed was falling.
For those in the devastating path of Hurricane Ike, it probably seemed like that was the case as water and wind ripped apart communities and caused several deaths, the extent of which we are not even yet fully aware. Likewise, for those directly impacted, the bankruptcy of the 158-year-old Lehman Brothers Holdings, Inc., may have exacerbated widening fears regarding the nation’s overall fiscal soundness.
Reactions to both traumatic events were swift, since similar incidents have happened in the past. However, this time there were some differences. Rescue was the name of the game along the Gulf Coast, but rescue, at least at taxpayers’ expense, was virtually nonexistent for the giant investment bank.
While the Chapter 11 filing of Lehman Brothers does not affect any of the broker-dealer subsidiaries, the sale of Merrill Lynch & Co., Inc., to Bank of America and the subsequent federal package for American International Group, Inc., are keeping worry about the financial future of the nation high on the radar of concern.
For victims of Hurricane Ike, uncertainties about the timetable for returning home and the conditions they will face when they arrive are causing severe apprehension and uneasiness. Fortunately, the problems experienced in providing assistance following Hurricanes Rita and Katrina have not been as severe because of better (though still not perfect) coordination and communication between government officials and volunteer groups.
To abate the mounting anxiety caused by the collapse of Lehman Brothers, the Federal Reserve is attempting to supply more cash to the financial system. To keep bank borrowing costs low, the Fed added some $70 billion to the reserves available to US banks and also widened its lending window by expanding the collateral it accepts for loans to securities.
Additionally, the Federal Deposit Insurance Corporation continues to monitor the situation and plans to step forward if necessary to mitigate any impact the recent actions might have on insured banks. However, more than 98% of the banking industry is well capitalized and expected to have the ability to weather the current storm. This strength is particularly noteworthy among Texas banks.
The dramatic drop in the stock market on Monday of this week, the steepest one-day fall since the terrorist attacks in September 2001, fueled speculation that the credit-market losses might worsen the economic slowdown. Prices at the pump jumped quickly (17 cents per gallon in the first three days, reflecting the fastest pace in three years) due to the brief standstill in supply. Fortunately, damage to refineries was not as severe as earlier projected. Still, it will take some time before the energy situation eases back to the more recent state of normalcy.
Oil prices closed below $100 per barrel on Monday for the first time since early March, as damage reports were less extensive than feared. Barring another threat to supply, oil prices are expected to remain lower as slowing economies constrict demand. Gasoline prices will likely soon follow.
Assurances regarding the overall soundness of the nation’s financial situation and commitments to action by the President, Treasury Secretary, FDIC, and others have caused the market to respond positively in attempts to make up a partial recovery. Likewise, as people begin to repair and rebuild along the Gulf Coast and as business operations that were affected gradually return to pre-Ike conditions, confidence in America’s ability to respond to emergencies, physical and fiscal, will undoubtedly be strengthened.
posted @ 08:05 PM CST [link]
Friday, September 12, 2008
The Other Storm
For some time now, communities across the US have been experiencing an historic rise in the number of foreclosures because of defaults on mortgage payments. Texas, while certainly not totally immune to this situation, has dodged the full brunt of the subprime collapse. In fact, in many areas, the real estate market remains reasonably healthy and prosperous.
This relatively good position is due in many respects to the state’s diverse and friendly business climate which has enabled countless businesses to expand their operations and create new jobs. It is also a reflection of the fact that Texas did not overbuild as much as other areas, and local developers pulled back when the problems began to surface. Unfortunately, this is not the case in most other parts of the country and, as a result, the housing industry has been undergoing a negative metamorphosis.
Sometimes, when faced with extraordinary difficulties, extraordinary measures must be taken. Such is the case in what happened this weekend when the US government placed the nation’s top two mortgage lending institutions in conservatorship.
To right the wavering housing market, the government took over Fannie Mae and Freddie Mac, which together either own or guarantee approximately half of the nation’s home loans (currently estimated to total around $5 trillion) and an even larger percentage of those being granted at present.
A variety of requirements were instituted as a part of the government’s new role in the housing industry, all of which are designed to diminish the turmoil in the nation’s financial markets and improve the ability of Americans to obtain loans. Although the total costs of this federal intervention into private enterprises are not yet known, no taxpayer loans or investments are on the immediate horizon.
Over the past year, the two mortgage giants combined lost some $14 billion, and the decision was made at the nation’s highest level to try to plug this drain. Even with the takeover, however, additional losses are likely to continue while the housing market strives to recover, but perhaps the leaking will eventually turn into only a slow drip.
A new government entity, the Federal Housing Finance Agency (FHFA), which was recently created by Congress, will now oversee the conservatorship. When US lawmakers formed the FHFA this summer, the Treasury Department was given greater power to make loans to Fannie and Freddie and to purchase their stock. With this takeover, the government will now have nearly 80% ownership of each.
To keep the companies from going broke and to bolster their capital cushion, the government is prepared to inject as much as $100 billion into each. Moreover, additional funds will be available if these changes fail to improve the housing situation and reinforce the national economy.
Fannie Mae and Freddie Mac buy home loans from various lending institutions and then repackage them as mortgage-backed securities which they either keep or sell to investors. Foreign investors, which in many cases include foreign governments, own about $1.5 trillion of the debt issued by the two corporations, as well as a few other agencies.
Many US financial institutions also have common or preferred stock in Fannie and Freddie. Just like with any marketable security in a bank’s portfolio, when the value of investment drops, the bank’s capital is affected. According to an assessment by the government, it appears that only a limited number of smaller institutions have holdings in these two entities large enough to impact their capital strength.
Both Fannie and Freddie have recently experienced a substantial drop in the value of their common stock. The conservatorship action does not eliminate this stock, but it does suspend dividends and places common stock shareholders on the bottom rung in terms of claims on the enterprises’ assets.
In recent weeks, borrowers with any credit blemishes have been finding it a bit more difficult to qualify for home loans, a process quite different from that which led to the current mortgage crisis. The takeover by the government is not expected to immediately create significant changes in the procedures for obtaining loans, but some analysts hope that the fees being charged by Fannie and Freddie (which have been passed on to borrowers) may soon be reduced. It is only fair to note that it wasn’t indulgence in lower quality, subprime loans that caused the problem. It was, rather, the steepness of the drop in the residential markets in some parts of the country that made even traditional loans become upside down.
The historic attempt by the government to reassure investors and keep borrowing costs from climbing upward is certainly not a full-fledged cure for the housing market maladies. However, it is a positive step, and over time, the results will provide an opportunity to review this matter more closely. Decisions yet to be made by Congress regarding the future of Fannie Mae and Freddie Mac will undoubtedly present a clearer picture of the wisdom of this unprecedented action. It was apparent, however, that something had to be done.
posted @ 07:59 PM CST [link]
Friday, September 5, 2008
Ill Winds and Still Rigs
Current estimates of the damage caused by Hurricane Gustav, while not as bad as we had feared, are running between $6 and $10 billion, thereby making it one of the 10 most costly storms in the nation’s history. With Hanna, Ike, and Josephine lurking not too far behind, further economic challenges are potentially looming on the horizon.
Since 1980, the United States has sustained 80 weather-related catastrophes with damages exceeding $1 billion each. About a third of them have been tropical storms or hurricanes, which have caused more than half of the $650 billion total cost of these disasters.
Fourteen of the hurricanes have made their way into the Gulf of Mexico, and while Florida has borne the brunt of the majority of them, the other four Gulf states—Alabama, Mississippi, Louisiana, and Texas—have also felt the devastating impact of the wind and rain associated with the storms. According to the National Oceanic and Atmospheric Administration Climate Data Center, the hurricanes that have struck the Gulf Goast have been among the most costly of all weather-related disasters in terms of property damage and loss of lives.
One thing unique to hurricanes that invade the Gulf of Mexico is that in addition to the deaths and physical and environmental destruction associated with them, storms in the Gulf waters pose a grave threat to the some 4,000 oil operations in the area, along with the more than 33,000 miles of pipelines. The oil drilling operations in the Gulf currently provide 1.3 million barrels per day, or about 25% of the oil produced in the US. The area also generates over 10% of the nation’s natural gas. Needless to say, any threat to these crucial resources can quickly push the economic fallout far beyond localized property damage.
In 2005, when Category 5 hurricanes Katrina and Rita struck with winds up to 175 miles per hour, approximately 3,000 platforms were affected, with 115 (including eight complete rigs) destroyed. Moreover, in excess of 50 platforms and 535 pipeline segments suffered severe damage.
When Katrina made landfall, many of the 56 refineries lining the coast experienced considerable damage. While it is rare for a hurricane to completely knock out all refinery operations, any disruptions ripple through the economy because the Gulf Coast refineries account for about 40% of the nation’s refining capacity.
Over the past three years, the oil and gas industries have made many adjustments in the Gulf area operations, including raising platforms, strengthening facilities, and burying pipelines much deeper than in the past. Extensive precautions and preparations for high winds and water have also been instituted.
As Gustav loomed dangerously close during the past few days, approximately 96.2% of the crude oil production was halted and three oil delivery pipelines were shut down. On average, a hurricane can stop oil drilling production for a week or so. Rig workers require two to three days to close the facilities and evacuate and about the same amount of time to inspect and gear up operations after the storm has passed, not counting the repair of any damage the facility may have suffered.
Last week, personnel on 626 production platforms (approximately 87.3% of the Gulf’s 717 manned stations) were evacuated, along with workers from 100 rigs, some 82.6% of those operating in the area.
Of the 32 major Gulf Coast refineries that process crude into motor fuel, 12 closed down and 10 others significantly reduced activity, thereby diminishing daily capacity by some 5.5 million barrels. Additionally, 25 of the 31 natural gas pipelines were shuttered, curtailing production by more than 95%.
Unlike the deadly Katrina and Rita, which were followed by steep hikes in gasoline prices, costs at the pump will probably not see a dramatic increase. This is due partially to the extensive preparations to enhance industry standards that have been ongoing since 2005.
Moreover, the devastation resulting from Gustav was not as widespread as that caused by Katrina and Rita. Some oil companies are even hoping to resume operations in the Gulf area this week.
There will likely be a tightening of gasoline supplies over the near term due to the shutdowns, even given reduced demand for fuel spawned by the economic situation the nation has been facing. However, depending on the amount of damage that is found to refineries over the next few days, the market should be able to adapt to the situation and enable consumers to weather at least this storm.
posted @ 08:02 PM CST [link]