Iceland: Wall Street on the Tundra

Michael Lewis, one of my favorite authors, has a great article on the collapse of the bubble in Iceland.

The whole article is well worth the read, but here are a few of my favorite quotes:

From 2003 to 2007, while the U.S. stock market was doubling, the Icelandic stock market multiplied by nine times. Reykjavík real-estate prices tripled. By 2006 the average Icelandic family was three times as wealthy as it had been in 2003, and virtually all of this new wealth was one way or another tied to the new investment-banking industry.

Global financial ambition turned out to have a downside. When their three brand-new global-size banks collapsed, last October, Iceland’s 300,000 citizens found that they bore some kind of responsibility for $100 billion of banking losses—which works out to roughly $330,000 for every Icelandic man, woman, and child. On top of that they had tens of billions of dollars in personal losses from their own bizarre private foreign-currency speculations, and even more from the 85 percent collapse in the Icelandic stock market. The exact dollar amount of Iceland’s financial hole was essentially unknowable, as it depended on the value of the generally stable Icelandic krona, which had also crashed and was removed from the market by the Icelandic government. But it was a lot.

It must have seemed like a no-brainer: buy these ever more valuable houses and cars with money you are, in effect, paid to borrow. But, in October, after the krona collapsed, the yen and Swiss francs they must repay are many times more expensive. Now many Icelanders—especially young Icelanders—own $500,000 houses with $1.5 million mortgages, and $35,000 Range Rovers with $100,000 in loans against them. To the Range Rover problem there are two immediate solutions. One is to put it on a boat, ship it to Europe, and try to sell it for a currency that still has value. The other is set it on fire and collect the insurance: Boom!

The world is now pocked with cities that feel as if they are perched on top of bombs. The bombs have yet to explode, but the fuses have been lit, and there’s nothing anyone can do to extinguish them. Walk around Manhattan and you see empty stores, empty streets, and, even when it’s raining, empty taxis: people have fled before the bomb explodes. When I was there Reykjavík had the same feel of incipient doom, but the fuse burned strangely. The government mandates three months’ severance pay, and so the many laid-off bankers were paid until early February, when the government promptly fell.

Back in April 2006, however, an emeritus professor of economics at the University of Chicago named Bob Aliber took an interest in Iceland. Aliber found himself at the London Business School, listening to a talk on Iceland, about which he knew nothing. He recognized instantly the signs. Digging into the data, he found in Iceland the outlines of what was so clearly a historic act of financial madness that it belonged in a textbook. “The Perfect Bubble,” Aliber calls Iceland’s financial rise, and he has the textbook in the works: an updated version of Charles Kindleberger’s 1978 classic, Manias, Panics, and Crashes, a new edition of which he’s currently editing. In it, Iceland, he decided back in 2006, would now have its own little box, along with the South Sea Bubble and the Tulip Craze—even though Iceland had yet to crash. For him the actual crash was a mere formality.

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The Housing Crisis Spreads to Europe

The housing crisis is not limited to the U.S. Last week S&P issued a warning that the housing markets in Europe and particularly in the UK and Spain are due a major downturn in a report titled “European Economic Forecast: Major Correction On The Cards As Housing Markets Turn Down.”

Business Credit Management reports:

"Europe's housing markets are overwhelmingly turning down. And in those countries where the housing bubbles have been expanding for longer, we believe the corrections could be severe and painful," said Jean-Michel Six, Standard & Poor's chief economist for Europe. "Particularly at risk are the U.K. housing market, where the financial crisis is exacerbating issues of affordability and general economic gloom, and the Spanish housing market, which is coming to terms with a largess of new homes."

Affordability has been declining constantly in the U.K. since 2001, with house prices averaging 3.4x incomes in the fourth quarter of 2007 against 2.4x at the same point in 2000. In turn, the rapid rise in prices has led borrowers to borrow more and over a longer period of time, pushing interest payments to 20.6% of incomes, the level they reached in late 1988 when the previous housing crisis began. Unlike interest rate shocks (such as in 1988-1991), affordability shocks cannot be reversed easily unless prices experience a severe correction. A simple calculation suggests that for the affordability ratio to return to its long-term average (early 1980s-late 1990s) of 2.5x, assuming incomes remain constant, prices would have to drop 27%. Ironically, a correction of this magnitude is close to the peak-to-trough fall in house prices expected in the U.S.

The combination of a sharp deterioration in affordability, scarce funding, and the economic slowdown are about to cause a major slowdown in the U.K. real estate market. Our central forecast assumes house prices to be flat or slightly negative on average in 2008, with a modest increase of 4% in 2009. This comes after years of double-digit growth.
…

Data released by the INE, the Spanish statistical office, on March 26, 2008, strongly suggest that the market has now taken a dramatic turn. In the 12 months to January, completed house sales were down a staggering 27% on the previous 12 months. Sales of second-hand dwellings, representing 52% of total sales, fell 36% over the same period, while sales of new houses were down 15%.

Permits for residential housing seem to suddenly be acknowledging the shift in market trends, falling 40.6% in the 12 months to September 2007 (latest data available). Judging by the experience of the U.S. market, this sudden and brisk drop in permits in Spain, if confirmed in the next few months, would call for a major collapse in housing starts. The dip in permits is particularly worrisome given that the Spanish economy is heavily dependent on growth in its construction sector. Indeed, one in five jobs created since 2000 in Spain is in construction.

HBOS, Britain's largest mortgage lender, just released figures showing that March home sale prices in the UK fell by 2.5%, from February, after falling just 0.3%, the month before.

The Telegraph reported last week that:

International banks are scrambling to sell their holdings of Spanish mortgage debt at a steep discount, fearing that the country may be sliding into the worst economic downturn in its modern history. A blizzard of grim data has soured the mood, capped yesterday by a plunge in PMI purchasing managers' index to an all-time low of 40.9. Car sales fell 28pc in March, and even Madrid's legendary tapas bars seem to have lost their late-night sparkle.

…
Traders says the market price for Spanish mortgage securities has begun to slide abruptly, replicating the pattern seen in the US last year. Large French and German funds and insurers appear to be liqudiating assets in a pre-emptive move, afraid being caught yet again in a violent downturn. Ismael Clemente, head of Deutsche
Bank's property arm RREEF in Spain, told a panel of experts in Madrid that foreign banks were now dumping Spansih mortgaged debt at a 40pc discount. Mikel Echavarren, director of the property consultancy Irea, said Spain's housing market was far weaker than the official statitics suggest, warning that prices could fall 20pc to 25pc. "All kinds of ploys have been used to disguise the true extent of the price falls, which we think are 5pc to 7pc already. Buyers have totally abandoned the market. We've had a wave of negative sales as people pull out of commitments already made," he said.

The Federal Reserve had a paper that looked at housing prices in 18 countries over a 35 year span. Adjusting for inflation, housing prices have traded in cycles. However during the last 10 years, housing prices have surged in most markets across the world.

This next table from the OECD gives a snapshot of the price to rent ratios and price to income ratios for each of the above 18 countries excepting Belgium. Spain and the UK topped the list in Price to Rent and where high on the list in Price to Income Ratios. The ratios were not that high in the U.S. compared to many other countries.

As discussed in this earlier post, Robert Shiller has some great long term graphs.

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An International Momentum Study

ABN AMRO released their annual Global Investment Returns Yearbook (hat tip CXO Advisory Group). Per ABN AMRO's synopsis “It is produced for ABN AMRO by London Business School experts Elroy Dimson, Paul Marsh and Mike Staunton, with a contributed chapter by Rolf Elgeti, ABN AMRO’s former Head of Equity Strategy.”

They have a database of stocks, bonds, and foreign exchange going back to 1900 for Australia, Belgium, Canada, Denmark, France, Germany, Ireland, Italy, Japan, the Netherlands, Norway, South Africa, Spain, Sweden, Switzerland, the United Kingdom, and the United States.

Here is a chart that they provided showing the correlation of the U.S., U.K., German, and Japanese stock markets since 2000. The returns are adjusted for inflation and are in the local currencies. So much for diversification.

They also have a chart showing how stocks have performed in the U.S. and the U.K. since 1900. $1 invested in the U.S. in 1900 would have grown to $239 by the end of 2007. With Dividends reinvested the $1 would have grown to $22,745. £1 invested in the UK would have achieved almost exactly the same results of £22,252 with dividends reinvested.

They also updated a study published by Griffin, Ji, and Martin in the Journal of Finance.

The original study took a look at stocks from around the world going back as far as 1975 up to 2000. The U.S. data went back to 1926. They looked at stocks that were in the top 20% and compared them to stocks that were in the bottom 20% in returns looking back 6 months. They found that the top stocks substantially outperformed the bottom stocks in the next 6 months. The gains reversed over 1 to 5 year timeframes.

The London Business School used a model that looked at the top 20% and bottom 20% stocks based on returns in the last 12 months. They would wait one month, hold for one month, and then rebalance.


Using this model, the top 20% stocks in the U.K. outperformed the bottom 20% by 10.3% since 1900.

Applying this model to 17 countries, they found that the top performing stocks outperformed the bottom stocks in 16 out of 17 countries since 2000. The exception was the U.S.

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World Stock Exchanges

It has been often said that when the U.S. sneezes, the rest of the world catches a cold. There was talk that with the growth in the emerging markets in Asia, that Europe and Asia have decoupled from the American business cycle.

The last two days have shown that the world still does fear a U.S. slowdown. With the American stock market closed on Martin Luther King day, the rest of the world had two days brew over recent developments. The results were not pretty.

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OECD's CLI Indicator and Economic Outlook

Today, the Organization for Economic Co-operation and Development (OECD) released their Composite Leading Indicators (CLI) for various countries in the world. It offers interesting insight into the pulse of the global economy. The indicators for the month of November are indicating a downturn in the U.S., Germany and the U.K. The rest of the OECD major countries’ indicators show a moderate slowdown. China’s indicator still shows strong expansion.

You can click on the graph to look at the full report.
Here is a graph of the CLI for the U.S. compared to the GDP and S & P 500 year over year growth in the US since 1955. You can click on the chart for a larger view.



Twice a year, the OECD publishes their Economic Outlook for the world. The last report was published on December 6, 2007. Click here for their synopsis. They predicted that the U.S. will stay out of recession, but lowered their projections on GDP due to three headwinds: housing turmoil, headline inflation, and financial turmoil. They point out that fortunately the headwinds hit us at a time when the economies are strong: world growth and trade growth are robust, profits are high and balance sheets are strong (enterprise saving has exceeded enterprise investment), business confidence was high, and unemployment was the lowest level in decades.

The OECD is projecting weak growth in the U.S. in 1% + range (not a recession) with activity to gradually accelerate mid 2008. They say growth will be dragged down by residential construction which will bottom out in the middle of 2008. Exports will be boosted by dollar depreciation.

They caution that their fairly benign outcome projections hinge on the headwinds not getting worse. In their press conference, the OECD said they don’t dare show their in-house model projections for the first quarter. They had to low ball and adjust downward the projections for the first quarter relative to their indicator models. They say that the risks to the downside are greater than to the upside, especially if any of the three headwinds worsen.

The slowdown isn’t just going to affect the U.S. Moreover, just like the mortgage crisis is not just a “Subprime” crisis, the housing crisis does not look like it will be limited to the U.S. Price to rent and Price to income for housing is elevated all across the world (Germany, Switzerland and Japan excepted).

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