Nouriel Roubini is a genuine expert on the difference between
illiquidity and insolvency: he wrote a whole
book on the subject, at least as it applies to countries. And now he’s attempting
to diagnose the present credit crunch as an
insolvency crisis rather than a liquidity problem. The thing is, telling
the difference is always more of an art than a science. And from my point of
view, a lot of what Roubini considers to be insolvency is reallly "just"
a liquidity problem. Liquidity crunches are bad, of course – but they’re
not as bad as insolvency. So the difference does matter, both in terms of the
severity of the present crisis and in terms of whether injections
of liquidity from the ECB and the Fed will be able to help.
So it’s worth examining the Roubini list of insolvents, to see which ones ring
true.
First on the list, of course, are homeowners:
You have hundreds of thousands of US households who are insolvents on their
mortgages. And this is not just a subprime problem: the same reckless lending
practices used in subprime – no downpayment, no verification of income
and assets, interest rate only loans, negative amortization, teaser rates
– were used for near prime, Alt-A loans, hybrid prime ARMs, home equity
loans, piggyback loans. More than 50% of all mortgage originations in 2005
and 2006 had this toxic waste characteristics. That is why you will have hundreds
of thousands – perhaps over a million – of subprime, near prime and
prime borrowers who will end up in delinquency, default and foreclosure. Lots
of insolvent borrowers.
No doubt there are insolvent subprime borrowers. They borrowed more than they
could afford, at high interest rates, and their net worth is now negative. What
about the Alt-A and prime borrowers? Delinquency rates are rising there, too,
as Nouriel notes, at least on the ARM front. We haven’t reached the worst of
the resets yet, and so one can’t take much solace in relatively low foreclosure
rates right now, either. But these are individuals with good credit, in an environment
where declaring personal bankruptcy is both very difficult and very harmful.
I have some hope that they will manage to muddle through somehow. Just because
you have a negative net worth doesn’t mean you have to default on your
mortgage. In general, though, I agree with Nouriel on this one: there is a lot
of insolvency among homeowners with recent-vintage mortgages.
Next are the mortgage lenders:
You also have lots of insolvent mortgage lenders – not just the 60
plus subprime ones who have already gone out of business – but also
plenty of near prime and prime ones. AHM – who went bankrupt last week
– was not exposed mostly to subprime; it was exposed to near prime and
prime. Countrywide has reported sharp losses not only on subprime lending
but also on prime ones.
This one I disagree on. There were a few subprime lenders who went bust relatively
early on because the banks put back to them a lot of the nuclear waste that
they underwrote. Yes, those were definitely insolvent. But AHM, and many of
the other mortgage-lender bankruptcies, I’d classify as more of a liquidity
problem than an insolvency problem. If it’s not owned by a big bank, a mortgage
lender is always at the mercy of its own bank lenders. If and when they pull
their credit lines, the lender goes bust, no matter how healthy its fundamentals.
The lender bankruptcies – certainly the more recent ones – are due
to liquidity being pulled, and are not due to insolvency.
Then come the home builders.
You will also have – soon enough – plenty of insolvent home builders.
Many small ones have gone out of business; it is likely that some of the larger
ones will follow in the next few months. Beazer Homes – a major home
builder – last week had to refute rumors of its impending insolvency; but
so did AHM a few weeks its insolvency. With orders for home builders falling
30-40% and cancellation rates above 30% a few will become insolvent over the
next year or so.
Again, I think this is a liquidity problem more than an insolvency problem.
If the homebuilders can simply access enough liquidity to be able to warehouse
their stock of unsold inventory for as long as it takes to sell it, they should
be fine. Insolvency only comes with serious double-digit house-price declines
– and while those do exist in some parts of the country, those are still
the exception rather than the rule.
Next come insolvent hedge funds – and I definitely agree with Nouriel
there. The magic of leverage can and will wipe out more than a couple of Bear
Stearns funds.
Finally comes the biggest and most contentious group of all: in a nutshell,
everybody else. Easy credit has brought default rates down to unnatural levels
in recent years: rather than declare bankruptcy, companies have been able to
refinance. Absent the easy credit, default and bankruptcy rates are going to
have to rise.
On this one, too, I agree with Nouriel. Default rates must rise from present
levels, and even if they only go back to their historical levels, that’s going
to be a big rise. I’m not convinced that a higher-but-still-relatively-low corporate
default rate will necessarily drive the US and the world into an apocalyptic
recession. But I do agree that there are some areas of the economy where an
injection of liquidity is not warranted, and might even be counterproductive
over the medium term. Lenders have been irresponsible of late; they’re going
to have to pay the price at some point, and there’s no reason why it shouldn’t
be a year or two from now when present loans mature and corporate bankruptcies
start rising.