Trouble For the Triple A’s
Paul Krugman has a good column this morning, States of Depression, where he’s noticed that cuts at the state and local level are accelerating and becoming a burden on the overall economy. I don’t always agree with Krugman but he’s dead-on with this one.
I’ve been studying housing finance reports extensively lately and can’t help miss how few of the AAA-rated tranches have taken losses. According to official reports everything is peachy-keen with the overall majority of houses in subprimeville.
Except that it’s not.
I’ve written extensively that there are a myriad of indicators showing that those losses are very real, that they will have to be accounted for, and that they’re coming soon to our front door.
For those not in the know, mortgages were bundled together into big pools — called securities for legal reasons, though they look like bonds in the same way a Siberian Husky resembles a wolf — under the notion that if you combine enough the whole pile cannot collectively fail. They were then divided into three sections, or groups, and each group usually divided into further subsections called tranches.
As losses hit these portfolios they were supposed to come from the bottom up, wiping out the lowest tier of the bottom group, then the next, and so forth. Sometimes this was changed slightly so losses from each group were held within the group itself, but it’s the same basic notion.
Most importantly, the bottom tiers were supposed to insulate the top-tiers. In fact, there was so much “buffer” built in that the top tiers they were deemed as safe as US debt by the ratings agencies and rated AAA; actually safer, given our shiny-new AA rating.
However, much of that buffer has been eaten away. Now that it’s gone we should be realizing the losses to the AAA’s but, rather, it’s “Houston (or, in this case, every other American city), we have a paperwork problem.”
Thanks to reckless, illegal, and unethical practices by mortgage servicers we really do have much worse than a “paperwork problem,” we had a fraud-fest that slowed down the foreclosure factory and delayed the losses. But that excuse is wearing thin and we have to face the more basic problem: we’re broke.
In much the same way that pooling together all those houses was supposed to make sure the whole collection could not fail, it made a countrywide (yes, that’s intentional) decline in house prices push down the entire pool. Rather than mark the losses we changed the accounting rules so that those losses could be delayed. Reality has a way of catching up though, and we’re about there.
Who invested in these AAA’s? Pension funds, life insurance companies, city, county, and state governments, college endowments; organizations that either should or were legally required to make extremely conservative investments. Know those annuities your uncle Lew said would always pay .. the money’s likely supposed to come from the AAA’s.
The number of people hurt by the micro-economic effect of the housing bubble and ensuing foreclosure fiasco has been relatively small, thanks to the bailouts. Love them or hate them — and I have to admit, I’m not such a big fan though I am beginning to understand them better — they buffered a severe blow to the economy.
All that will change soon as the AAA’s topple. It’s not a question of if, just when .. and when comes closer every day.
Uber analyst Meredith Whitney famously predicted widespread municipal failures, and was famously “wrong” as muni bond prices declined thanks to some magic force propping up the market. That force is called fraud, accounting fraud, and those muni’s will melt to mush. Just like Jefferson County’s sewer system left the residents there in the financial crapper, so too will those AAA’s; they’re a cancer that’s being ignored (“Judge .. can we delay this sale a sixth time,” asks the bank lawyer).
I’m thinking of a comment I read a couple years ago from a man who said that he’s worked as a state government employee his whole life but who’s now retiring and moving to a different country to enjoy low taxes. Somehow this putz didn’t see the correlation between his cushy lifelong pension to those same taxes.
Hopefully he’s having fun because it won’t be long until those fat checks for the tax-hating fat-cat bureaucrat will take a Marine-style haircut.
It’s virtually certain that a large percentage of his checks, and those that fund and fuel local spending, are invested in those AAA’s, and that those losses have not been accounted for. At one point towards the end of last year Florida’s pension fund was reporting an 18% return, in a year when most hedge funds reports losses, thanks to the delusional way we account for AAA losses.
Maybe the people of the city, county, or state he “served,” with resentment will be willing to see their property and sales tax tripled to support sending pension checks to far-flung ingrate retirees like him. Somehow I doubt it, especially since the anti-government feelings he embraces are widespread, and taxpayers resent being taxed for retiree pensions they themselves don’t have. More likely are upcoming municipal bankruptcies to thrown him, and those like him, under one of the soon to be idled buses.
Whitney is right but, thanks to fraud, her timing was off. When those losses start to hit everybody will feel the pain. Schools will be shut-down, services slashed, and fees increased. Soon we’ll be Greece, with fewer islands and lousier food.
One day we’ll look back upon the last few years and wish we’d had an honest discussion about how to quickly push down those principal levels and put a real floor on the housing market — and the structured finance products behind it — rather than the dysfunctional dialog that’s been ongoing.