PIMCO's Bill Gross explains why the markets for houses, stocks, and bonds are all crashing at once--and why they all have much farther to go. In a sentence? The global economy is in the process of delevering (reducing debt by selling assets):
What Happens During Delevering
- Risk spreads, liquidity spreads, volatility, term premiums – they all go up. [Which is happening now]
- Delevering slows/stops when assets have been liquidated and/or sufficient capital has been raised to produce an equilibrium.[Hasn't happened yet]
- The raising of sufficient capital now depends on the entrance of new balance sheets. [Rapidly running out of these. That's why Lehman's in Korea] Absent that, prices of almost all assets will go down. [Happening now]
Specifically, Gross argues that the bursting of the housing and its accompanying credit bubble have forced banks, GSEs, and households to shed assets at an unprecedented rate. This has lead to an avalanche of asset devaluation, the likes of which haven't been seen since the Great Depression.
Also, argues Gross, the mass liquidation of real estate assets has infected other asset classes, which has triggered a slump in asset prices not seen since the 1930s:
[T]he volatility associated with asset liquidation as well as the observable lack of liquidity adds additional risk spread premia, which in turn lower the price of almost any stock, bond or piece of real estate that you or anyone else owns. In combination, the current delevering has managed to sink all three primary asset classes in aggregate.
The result: a financial tsunami that is only just beginning:
[A] 10% aggregate asset price decline does more than make us all 10% less wealthy. Because many of these assets are leveraged and margined, the more they decline, the more frequent and frenzied the margin calls, and if the additional cash flow is not provided, not only an asset liquidation but a debt liquidation follows. It is the debt liquidation that potentially turns a stagnant/recessionary economy into something much worse.
In the housing market for instance, it is one thing to observe a 15% national decline in home prices. It is much more serious however, when margin calls in the form of monthly mortgage payments (many of which are increasing due to adjustable or option-related contractual provisions) lead to foreclosures, which in turn cause a debt liquidation. The bank in this case, takes possession of the home and dumps it back on the market, lowering the price even further, which leads to more foreclosures...
The solution to the crisis? In Gross's opinion, massive government invention. Unless "new balance sheets" are found to break the cycle of asset and debt deflation, we're toast.
New balance sheets? Is this now some Deloitte & Touche metaphor? Hardly. What I mean, what our blackboard and our Investment Committee point out is that to ultimately stop this asset/debt deflation, a fresh and substantial new source of buying power is required. This became all too obvious as the Treasury’s attempt to entice additional capital into Freddie and Fannie came up empty. Yet this same dilemma is and will continue to confront all highly levered institutions in the throes of asset liquidation. Without a new balance sheet, their only resort is to sell assets, which in many cases leads to further price declines, or ultimately debt liquidation/default.
[I]f we are to prevent a continuing asset and debt liquidation of near historic proportions, we will require policies that open up the balance sheet of the U.S. Treasury – not only to Freddie and Fannie but to Mom and Pop on Main Street U.S.A., via subsidized home loans issued by the FHA and other government institutions. A 21st century housing-related version of the RTC such as advocated by Larry Summers amongst others could be another example of the government wallet or balance sheet that is required during rare periods when the private sector is unable or unwilling to step forward.
Of course, even with access to the Treasury's balance sheet--which is what Bill is stumping for--asset prices will still fall, and the workout will still take time. Which is another reason why we don't think this is over.
See Also: About That Crashing Stock Market...
