Saturday, December 15, 2007

I only hope that when the data is analyzed...

... a strength can be found. Or at least, that's FGIC's only hope. Moody's placed the erstwhile GE subsidiary on negative watch late on Friday. When I first started my career, FGIC had the reputation for being the most conservative of the major insurers. Now they are the one in the most trouble. Moody's also put XLCA (subsidiary of SCA) on negative watch as well. Both will need to raise capital over the next couple months if they want to keep their gilt-edged rating.

We've speculated before on this blog about FGIC, which seemed particularly vulnerable given the fact that majority owner PMI is having their own capital problems. But it's not over yet. Moody's didn't give a number to how much capital FGIC might need, but I suspect they've given such a number to FGIC management. So the odds are good that FGIC is already working on a capital plan.

MBIA was affirmed, but given a negative outlook. It sounds like as long as the previously announced capital plan is completed, the negative outlook will be removed. Interestingly, MBIA's current capital is below the Aaa target level, but their captial is adequate under the stressed scenario (albeit just barely). XLCA is above the target level now, but would fall below under the stressed scenario. I guess that is saying that MBIA has stuff in trouble now, but XLCA has stuff that could really blow up on them if things get worse.

AMBAC, which has been my whipping boy only because they provided enough info to do a deep dive, has been affirmed with a stable outlook. Moody's believes that AMBAC has enough capital even before the recent reinsurance deal with AGO. This is evidence to support my conspiracy theory: that Moody's tipped off the insurers as to how much capital they'd need. That's why AMBAC was confident that reinsurance would be enough when they presented at a Bank of America conference.

Assured, FSA, and Radian were also affirmed with stable outlooks. Radian is the interesting story here, since their traditional mortgage insurance business has the holding company struggling, but they've actually capitalized the bond insurance business separately, and the insurance arm has very little in mortgage exposure.

This is all great news for MBIA and AMBAC, and not unexpected for FGIC and XLCA. But its not the end of the story for any of them. I'm on record that AMBAC will wind up with larger losses than what their capital currently supports. So I think as time passes, AMBAC (and probably MBIA also) will have to raise additional capital. Its possible losses come in slowly, and therefore the required extra capital is small enough in any given year as to not require drastic measures. That seems to be what Moody's is saying.

We'll see how the muni market reacts on Monday.

Disclosure: No positions in any company mentioned other than insured municipal bonds.


PaulinKansasCity said...

What are your thoughts on the student loan CDO market? FMD's last securitization had AMBAC involvement; looking at that stock tells me no one will ever be able to obtain a student loan again!

cak said...

AMBAC did mention that they were looking at additional measures --
There was also a small blurb out of Wilbur Ross, although I don't know if that is good or bad.

"Reinsurance is a valuable, capital efficient and shareholder friendly tool for managing risk and capital in the financial guaranty industry," said Robert Genader, chief executive officer of AMBAC.

The deal is part of the company's broader plan to raise capital, according to a company spokesman who declined to comment further."

NEW YORK, Dec 13 (Reuters) - Billionaire investor Wilbur Ross, who recently has been snapping up mortgage assets at fire-sale prices, told CNBC on Thursday that hard-hit monoline insurers could be another attractive area for investment.

"We're looking at the monoline insurers. They all need capital," said Ross, who runs New York investment firm WL Ross & Co. "It seems that if you can find one make it through without losing its triple-A rating, that could be a very good investment." (Reporting by Joseph A. Giannone; Editing by Jeffrey Benkoe)

Dave M. said...

AI said.."Radian is the interesting story here, since their traditional mortgage insurance business has the holding company struggling, but they've actually capitalized the bond insurance business separately, and the insurance arm has very little in mortgage exposure.""

Why are Radian insured munis being discounted then? Yes, I also own some munis what Radian insurance as well. Sigh.

EJ said...

The new policies that AMBAC and MBIA are writing are at higher rates than the policies that run off.
That brings in extra capital over time.
So, higher risk in their portfolio is at least partially compensated for by higher premiums. That's a nice helpful correlation in their business model.

EJ said...

AMBAC has been affirmed at stable AAA by Moody's.
Somewhat unexpectedly, AMBAC comes out better than MBIA.
Moody's is clearly not agreeing with the back-of-envelope worst case scenarios that some outside analysts have put up.

This is some info about Moody's stress-case:
"Our stress-case analysis is intended to approximate an environment where subprime first lien mortgages underwritten in 2006 suffer, on average, 19% cumulative losses (vs. Moody’s current estimate of approximately 11%), with loss assumptions for other RMBS collateral types and vintages scaled according to their anticipated performance relative to 2006 subprime RMBS."

Question: does this stress case seem still too optimistic?

Anonymous said...

You are all re-arranging deck chairs on the Titanic.

Anonymous said...

AI: What do you think are the prospects of the CMBS that Radian is backing? CMBX seems to have bounced back recently, and default rates have remained far less severe than for mortgages.

Anonymous said...

So according to the bond market association, there is about $12 trillion in mortgage debt outstanding. Ben Stein has suggested home prices need to fall about 15%, Robert Schiller says 30%.

Lets go with Stein, just because its the lower number. That would be $1.8 trillion in losses that need to appear on someone's book before the mortgage "crisis" is over.

Public announcements amount to about $100 billion plus or minus so far?

That leaves $1.7 TRILLION more in losses that someone has to take before the market can be called "mark to fair value". Of course, market to market often over reacts, and if you believe Schiller, than we have double that amount to go.

For comparison, the S&L debacle in the 1980s, adjusted for inflation, would be about $900 billion.

Between home owners, investor/ speculators and insurance companies -- someone needs to take in aggregate a $1.7 billion write off before the markets can stabilize.

This doesn't mean the sky is falling-- this too shall pass. It just means the sky will fall unless and until market participants come clean.

Until then, the best use for Moody's reports is for kindling in your fireplace

gramps said...

I think Ben Stein's estimate may prove a little optimistic, and Schiller's a little pessimistic. However, I agree someone (a lot of someones) needs to show a big loss before the market will stabilize.

May I humbly submit two possible names:

cak said...

AMBAC has stated that re-in is the first line of defense. If you can believe mgmt, they are securing additional lines. Depending on how smart these guys are, and they founded this business, they will adopt the "depression siege" mentality and work from there. It's AMBAC vs. Wall St. We'll see if if ends up Pavlov's House or the dog house. (Google Pavlov's House)

gramps said...

I am surprised everyone is obsessed with AMBAC, FGIC and MBIA... the two biggest "insurers" of mortgage debt also have the greatest leverage / lowest capitalization of any.

FNMA just lowered its dividend and raised about $7 billion in additional capital, which brings them to about $49 billion or so?

If FNMA was to be capitalized like Citibank (itself not a poster child of conservatism) at 7%, its $2.7 trillion portfolio would need about $190 billion or almost four times its current level.

This ignores all the "off balance sheet" guarantees for which it was paid a fee.

FNMA says it has $420 billion in subprime debt currently. Lets say the subprime turns out to have a 90% recovery rate (10% loss)-- which is rather optimistic. That alone basically wipes out FNMA's capital.

I have argued repeatedly (and I think AI agreed?) that this problem is much bigger than just subprime.

I am sure someone is going to say the government will never allow FNMA to fail-- its too big and too important to the mortgage market. So does that mean the tax payer is going to eat the loss?

Proton said...

FNMA & FRE are too big to fail. Yes, there is no explicit government guarantee but they can't be allowed to fail at this time.

House prices can decline 30% or more over many years, but it does not follow that the mortgages would experience the same amount of losses. Taxpayers will ultimately absorb the cost. Besides, most companies do not mark to market. They would take occasional charges here and there, trying to convince the investors they are fine until the last possible moment.

These aside, I would not count on any "insurance" or "wrap" from monolines. Moody's may think they may be worth Aaa, but who are they kidding? These companies are 1:100 times levered; most of them (including AMBAC and MBIA) are sitting on mark-to-market losses multiple times of their capital amount.

As the monolines themselves state: they don't have to mark to market and they don't have to post collateral. So long as the regulators are asleep on the wheel AND if the market values of mortgages and CDOs eventually recover some, they would be fine.

Do they have the same risk as the US government then? Rating agencies will say that because they get paid for saying it. This whole credit crisis will not be over until the investors can trust the rating agencies.

cak said...


Thanks for your post/ Can you please state for the record, from your sources, that the monolines are not required to "mark to marke and post collateral". Specifically, which co, has stated to you, in fact, that this is the case?

cak said...


The fact is, there are NO regulators. This is a liquidity crisis. Granted, as you believe, as I do, that Congress should exhert more influence to clean up this problem (and believe me they WILL!) we need to stand behind our President, support the Hope Now inititiative and do what is right for the country.

Sivaram Velauthapillai said...

CAK: "Can you please state for the record, from your sources, that the monolines are not required to "mark to marke and post collateral". Specifically, which co, has stated to you, in fact, that this is the case?"

Monolines have to mark-to-market although it may or may not mean much depending on the final outcome.

As for posting collateral, monolines generally write contracts saying that they don't have to. Read this FAQ from Ambac (it's generally the same for other monolines).


AMBAC FAQ: "No collateral posting requirement. Ambac’s CDS documentation does not require the posting of collateral either upon a downgrade of Ambac’s rating or upon a downgrade of a bond wrapped by Ambac "

Sivaram Velauthapillai said...

anon: "Public announcements amount to about $100 billion plus or minus so far? That leaves $1.7 TRILLION more in losses that someone has to take before the market can be called "mark to fair value". "

A sizeable chunk of the losses will be transparent losses by homeowners. If the house price on your street drops then everyone on your street will take a paper loss. But most will not "mark" that anywhere (except through indirect effects like lower spending due to wealth effect). People will still keep living in their house and make the mortgage payments.

You will also see big losses by hedge funds. We may never find out how much is lost by hedge funds (since they operate in a dark world without any public disclosure) but it is likely to be pretty big.

Overall, though, the paper loss of trillions likely won't be real losses marked anywhere.

cak said...

Siv -

Thanks for the post. What do you think of this post from MISH (granted he is a major bear on the monolines)?

Ambac Blows It ... Again

News is out that Ambac Reinsures $29 Billion Portfolio to Keep Rating.

Ambac Financial Group Inc., struggling to avoid the crippling loss of its AAA credit rating, took out insurance on $29 billion in securities it guarantees. The world's second-biggest bond insurer agreed to transfer the risk that the securities will default to Assured Guaranty Ltd., according to a statement today. Reinsuring the debt will free up capital backing those bonds, Ambac said.

Ambac guarantees $556 billion of securities and the loss of its AAA rating jeopardizes the rankings on that debt as well as threatens the New York-based company's biggest source of revenue. "Reinsurance is a valuable, capital-efficient and shareholder-friendly tool for managing risk and capital," Ambac Chief Executive Officer, Robert Genader said in the statement.

My Comment: Reinsurance on $29 billion out of $556 billion is unlikely to do anything but waste money. Right now this it is too little, too late, and on the wrong stuff. It certainly is not shareholder-friendly. At best, all it will do is dilute future earnings.

A loss of the top rating would wipe out Ambac's main business of guaranteeing debt. If all the companies were to falter, $2.4 trillion of insured securities would be thrown into doubt, costing as much as $200 billion, according to data compiled by Bloomberg.

Assured Guaranty has less risk than its competitors from mortgage-related securities, the rating companies said. Fitch affirmed Assured Guaranty's AAA insurance and reinsurance ratings yesterday after the company announced a plan to raise $345 million through share sales and give the proceeds to Assured Guaranty Re Ltd. so it can reinsure more deals.

My Comment: Fitch is in no place to affirm anything. For a good look at Fitch's competence, please see Fitch Discloses Its Fatally Flawed Rating Model.

The debt reinsured by Assured includes structured finance, public finance and international securities, Ambac spokesman Peter Poillon said. Assured won't reinsure any CDOs, he said. Poillon declined to comment on the amount of capital freed up by the deal.

My Comment: Poillon would not comment on the amount of capital it freed up because the amount was likely negligible. The big problem for Ambac is CDOs and Assured Guaranty Ltd. apparently was not dumb enough to reinsure those.

Ambac insures $8.8 billion of securities backed by subprime mortgages and $29.2 billion of collateralized debt obligations that repackage pools of subprime mortgage debt and slice them into new pieces with varying degrees of risk, according to the company's Web site.

My Comment: Ambac did nothing to address the core issue: what to do with $29 billion in CDOs and another $8.8 billion in subprime slime. All Ambac accomplished was selling of assets that were likely good while retaining garbage that likely was not.

Anonymous said...

CAK: The fact is, there are NO regulators.

What country are you from? At the Federal level alone: Fed, Treasury, OFHEO, HUD, OCC, and at least four different Congressional committees. Every state has its own hodge podge of regulators-- all of whom have been in full operation for decades and were in operation as the current fiasco was created.

CAK: This is a liquidity crisis.

Wrong. Smart money isn't having any trouble getting funding. People who have demonstrated poor risk management are justifiably not getting funding.

CAK: Granted, as you believe, as I do, that Congress should exhert more influence to clean up this problem (and believe me they WILL!) we need to stand behind our President, support the Hope Now inititiative and do what is right for the country.

Again, I wonder what country you live in. Are you aware Congress and the President are from different parties? Who is this "our President" you want to get behind? Would that be the one with 25% approval ratings (ie the one with 75% disapproval)?

If you want us to get behind YOUR President, should we get behind him when Bernanke and Paulson of a few months ago, when they were saying the housing situation was minor and not likely to amount to much; or should we get behind the Bernanke/Paulson of today who thinks the sky is falling and therefor we should abandon centuries of contract law?

If what they were proposing was legal, mortgage borrowers and lenders could go do it on their own, without Treasury or Congressional "legal cover" as AI likes to call it. You only need legal cover when you are doing something shady.

Please take your silly political advertisements elsewhere.

gramps said...

I think the FNMA/FHLMC "too big to fail" argument needs some rethinking.

I have been reading a lot of other blogs where people have made the counter argument "Too big to save". Not sure I necessarily agree, but they make a number of really good points.

1. The next President, whomever it turns out to be, will be the first President in our nations history to face serious fiscal headwinds: according to the government, Medicare becomes cashflow negative in 2009. Social Security isnt projected to be cashflow negative until 2017, but it is expected to be about cashflow neutral from 2011-2017. Uncle Sam is not a bottomless pit of money any more than the British or Roman empires were.

2. We are seeing a tremendous transfer of wealth happening. Sovereign wealth funds now hold well over $2 trillion in government debt, plus huge investments in Blackrock, Citi, and others. I will leave the xenophobia to others, I want to focus on the economics. Sovereign wealth funds do not pay taxes -- whatever else it is, this wealth transfer is a massive erosion of the tax base

3. A deficit in one year (trade or budget) is largely an irrelevant accounting artifact. But persistent deficits, year after year, are an erosion of wealth and an erosion of the tax base.

4. Its not as though the government hasn't already made some pretty significant efforts to "solve" the crisis already. Fed Funds are down 100bp and have had virtually no effect domestically. Internationally, our "omnipotent" government has managed to severely damage the world's faith in our system-- and its not *just* Iraq.

5. When NYC went defacto bankrupt in the 1970s, most of the debt holders were banks "able to take the hit". When the S&L and Latin American debt crisis hit in the 1980s, it was mostly petro dollar recycled money -- again "able to take the hit". In the current crisis, which is MUCH bigger, Joe Homeowner is taking the hit. Given the US savings rate is basically zero, its not clear Joe Average can take the hit without a significant drop in lifestyle. As Warren Buffet has pointed out, we cannot continue to live beyond our means indefinitely.

There is no such thing as "the government" -- its just a legal entity. In the end, the government is you and me (you may remember that "We the People..." thing?). If we have no money, than our government doesn't either.

When all is said and done, I think a good argument can be made that FNMA and FHMLC are too big to save -- except via massive inflation. Ask any banana republic you like: inflation isn't really a "fix".

mkmuny08 said...

You are wrong. This stock is gold. This is why you do work for ABK. Guessing seems to be everyones analysis lately. Maybe they are hiring soon, they have plenty of extra capital. This is a buy all day long and they should be a role model to all Insurers going forward. They will get all business going forward.

Sivaram Velauthapillai said...

CAK: "Thanks for the post. What do you think of this post from MISH (granted he is a major bear on the monolines)?"

I'm actually bullish on Ambac and am planning to take a position in it (check my blog for my thoughts). Nothing is certain until I purchase it but that's my thinking so far (I'm just a newbie investor so don't blindly follow anythign I do--I'm having a terrible year BTW :( ). I'm curious to see what Fitch says. So I might be biased towards Ambac :)

As for MISH, well, his arguments aren't strong enough to change my bullish view. His arguments seem to attack the credibility of rating agencies, Ambac's management, and so forth, but I'm more worried about the performance of mortgage assets. It's easy to argue that some company shouldn't have bought back stock or paid out dividends, or whatever, but if hardly anyone--including the market--didn't predict an event, I don't fault people.

The strongest bear case is from Bill Ackman (of Pershing Square). I'm actually kind of scared of him because he is a value investor (meaning that he is looking bottom-up and doesn't like what he sees). If he were a trader or a growth investor or some other investor making the statement, it wouldn't be strong in my eyes but going against a successful value investor scares the hell out of me. Read his full presentation from the Value Investing Congress if you want to see the superbear case.

As Wilbur Ross was saying last week, the mononline that survives will do very well. So one needs to figure out if Ambac (or someone else) will survive. The business model makes sense (how could they have stayed in business since the 70's otherwise?). But the losses are creating uncertainty. If I ever take a position, it will be with an expectation of a maximum of $4 billion in losses. Anything more and this company is in trouble.

So far the battle seems to be:

BEARS: Bill Ackman, Reggie Middleton, MISH

BULLS: Martin Whitman, specialist investors (like Warburg Pincus), Wilbur Ross (no position but seems to like the business and will likely provide capital (he invested in beaten-down reinsurers after Katrina))

Sivaram Velauthapillai said...

Accrued Interest gets a mention at the Fortune blog:

congrats :)

Accrued Interest said...

Holy cow. Shouldn't post on the weekends because I can't keep up with the comments.

Paul: Do you mean student loan ABS? I don't believe there were any student loan (only) CDOs. As far as I know, student loan ABS have gotten cheap (or expensive from the issuers perspective) but are still going off. I'm not real involved in that sector.

Dave M.: The muni market is slow to forget, and they never really trusted Radian anyway. The concept of a non-Aaa rated insurer is hard for most of the muni market to understand.

Anyway, it looks like Radian's bond insurance arm is in OK shape. If the parent goes under because of trhe mortgage insurance business, that's separately capitalized. So the bond insurer could go into run off and still pay most of its claims.

Accrued Interest said...

EJ: Your point about better pricing power on new muni issues may or may not be reality. It depends on whether muni buyers continue to value insurance as they have in the past.

And 19% cumulative losses is pretty steep on normal RMBS. Remember that's not default rates but loss rates. Even in today's depressed market, you'd expect to recover 40-50% of value in foreclosure. Now on HELOC that number is going to be lower, obviously. So I'd like to see what their specific default and recovery assumptions are, as opposed to a blanket 19%.

I think 2006 vintage subprime defaults will be in the 25-30% area. 25% would be about the number of subprime loans done with limited documentation.

Accrued Interest said...

Anon on CMBS: Does Radian have much in CMBS? I knew they had a lot of synthetic CDOs backed by corporate CDS.

My opinion is that CMBS and corporate bond defaults will be within historical "recession-level" norms. CMBS would make me a little more nervous, since commercial RE has had quite a run.

Accrued Interest said...

Anon w/ the $1.7 TRILLION!!!!! number.

I agree with the other comments that this number, while correctly calculated, doesn't have anything to do with anything. I think the S&P 500 had a market cap of like $12 trillion at the end of 1999. By the end of 2002, it had fallen 40%, or something like $4.8 trillion dollars. But for most people, this was scary, but was only paper losses. We had a recession too, but it wasn't the end of the world.

My wife and I were talking yesterday about this, and we figure we've lost $30,000 on our house since the peak of the market, if you believe the comps in our neighborhood. But we've been in the same house since 2001, and have close to 50% equity. No one needs to write anything down here. The bank that holds my mortgage isn't in any more risk now than at the peak.

Accrued Interest said...

Gramps: The problem is indeed bigger than just subprime. We see that in prime delinquency rates, which have ticked up. Granted, they aren't moving like subprime DL rates are moving, but still its not an irrelvant problem.

As far as whether FNM and FRE are too big to fail, I think they are. But still, I'd put relatively low odds on them actually "failing." Here I'm assuming failing means they run out of cash and need a bailout. The other day FRE announced they'd be advancing interest on defaulted loans rather than buying out the mortgage. They could retain a TON of capital by doing this.

Accrued Interest said...

To Sivaram and CAK, thanks for commenting. I feel as though you have done a good job responding to each other. I am more sympathetic to Sivaram's points. I think that in the next 2 years, AMBAC has to raise substantial additional capital, but that they'll manage to do it.

Sivaram: Almost famous now. If only I could figure out a way to make the blog pay the bills, I'd post all day long!

PaulinKansasCity said...

accrued; i meant ABS; i was in a hurry and got sloppy. your note is a good reminder. I agree the student loan ABS has gotten more expensive for the issuer; I would think that investors would demand more spread versus libor; I believe banks underwriting private student loans would also reprice accordingly and this would work it's way into underwriting practices this quarter and definitely 1st quarter 2008. Thanks!

gramps said...

OK, so I guess when we ask if FNMA and FHLMC are too big to fail, we need to define "fail"...

I think we would all agree they will not be allowed to fail, defined as padlocking the doors closed.

If we define failing as: they have to stand on their own two feet without help from Uncle Sam (which is the same criteria you would apply to any other "independently capitalized" for profit entity) -- I would say the odds are very good that they will fail.

Yes I know. They are independent, but they are not, but they are, but they aren't. That sort of confusion may help those of you who are betting on literal Chapter 7 bankruptcies -- but its a big problem if you are trying to regain credibility on the world stage. Paulson looks and sounds foolish when he tells Asians and Europeans not to manipulate their markets -- but then does so here.

Kiss the Doha rounds goodbye (pretty much dead anyway) and plan on lots of protectionism -- a la Great Depression.

Personally, I would think Uncle Sam will throw a bit of money FNMA and FHLMC's way -- but as I alluded to in the earlier post: Uncle Sam has some pretty serious money problems of his own, and they are likely to get worse.

Check out the situation in California. Despite the Gubernator's promises not to rob the future to pay for the present, he is doing exactly that. The tax base has been eroding for years, and the real estate drop is pushing California over the edge. Government spending has skyrocketed (growing much faster than the economy was even during the housing boom). Gubernator has ruled out raising taxes, although most people don't consider that a credible option even if he was willing. He hopes to pull a Gray Davis and issue piles of debt (he has even mentioned $500 BILLION as a figure?). He swears he won't cut spending, but most observers think he (or his sucessor) will be forced.

Uncle Sam is in the same boat. Hopelessly spending money he doesn't have. Hopelessly unable to truly balance the spending and revenue -- please don't anyone on this blog act like a member of Congress and start babbling accounting tricks. Uncle Sam has spent more than he took in EVERY year since Kenedy was President. Clinton had lots of stuff off budget, Enron style. Maybe fooled you, but not me.

The only thing Uncle Sam has that California doesn't (and this is big) is Bernanke's printing press equipped helicopter.

That is the only credible means Uncle Sam has to deal with FNMA, FHLMC, Citi, Wamu, Countrywide -- not to mention the entitlement programs.

I suppose that technically you will get your dollars back-- but they will be worth a lot less.

Ask supermodel Gisele (or anyone who grew up in a banana republic) -- that isn't really fixing anything.

gramps said...

BTW -- will someone please explain why bloggers are yelping about "deflation" to justify flooding the world with even more credit?

Its really nonsense. First of all, you have to qualify this as "asset deflation", as opposed to "cost inflation".

The cost of living is undeniably going up 6-7% per year or more. Wall Street yuppies don't get this, but every middle class registered voter does... and its a big big big problem.

The cost of living for 95% of the population has been rising much faster than their incomes for many years. For a time, this problem was "solved" by taking out home equity loans / refinancing. That obviously isn't going to work now.

When Wall Street talks about deflation, its very obvious that THEY don't get it.

As for asset deflation, Wall Street already decided (over the last decade or more) that it doesnt count. Sorry guys, but if it doesnt count on the way up, you sound foolish when you try to count it on the way down.

If you want to count the current deflation, than CPI (and incomes) need to be marked WAY up to adjust for the last decade's massive up trend. Since no one is willing to do that, the down trend doesnt count either.

Wall Street's delusional notions about income and cost of living is why we all got "surprised" when mortgage land fell apart. The signs have been there for years-- go back and count all the articles about the "housing ATM". Inflation is a huge problem, and with food, energy and raw material prices rising worldwide -- its going to get worse.

Sivaram Velauthapillai said...

GRAMPS: "BTW -- will someone please explain why bloggers are yelping about "deflation" to justify flooding the world with even more credit? Its really nonsense. First of all, you have to qualify this as "asset deflation", as opposed to "cost inflation".

I'm in the disinflation/deflation camp so let me take a stab at answering it.

Asset deflation always causes price deflation. Whenever there is price deflation you are almost certain to lose the wealth multiplier effect and hence result in declining prices. In other words, when asset prices drop, consumption generally also drops. This drop in demand causes prices to drop. You can look at all the classic asset deflations of the past such as the Great Depression, Japan in the 90's, and so forth.

"The cost of living is undeniably going up 6-7% per year or more. Wall Street yuppies don't get this, but every middle class registered voter does... and its a big big big problem. "

I don't know about the person on the street but the market definitely doesn't think so. If inflation is anywhere near what you say it is then stocks and bonds will be discounted a lot more. So far the market hasn't done that.

"The cost of living for 95% of the population has been rising much faster than their incomes for many years. For a time, this problem was "solved" by taking out home equity loans / refinancing. That obviously isn't going to work now."

First of all, a lot of the equity loans are not to cope with inflation but for discretionay spending. Most people who withdrew money from their homes, or liquidated profitable stocks, or borrowed money, or whatever else, did so to increase their discretionary spending. I don't think they were doing it out of necessity. If you don't believe me, look at the performance of luxury retailers vs discount retailers over the last 5 years.

Anyway, now that they won't be using home equity withdrawls and the like, isn't that going to cause prices to drop? I mean, if people don't have money, they are not going to buy; they are going to conserve.

"When Wall Street talks about deflation, its very obvious that THEY don't get it."

I don't know who Wall Street is. There is clearly a dichotomy right now. On one side you have all the inflationists, who have pumped hundreads of billions into commodities, emerging markets, and other equities thought to benefit from inflation. On the other side, you have the deflationists, who are going into US treasuries, have shorted a lot of the inflation-benefitial equities, and so forth. So I don't think there is one dominant deflation view.

We'll know who is right very soon... I'm thinking before May 2008...

Accrued Interest said...


I haven't been talking about deflation in general. Asset deflation so far has been limited to real estate.

I agree with Sivaram that the housing market would likely cause deflation, except that I believe the Fed's actions will head off generalized deflation.

I also think the Fed is currently fighting a "tail risk" of multiple bank failures. They will wind up cutting more than would typically be expected given the economic fundamentals. So that will likely cause some acceleration of inflation.

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