Heading Weekly Musings 43 11-7-11
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The Pareto Distribution: Europe at the Tipping Point?
Those 4% "vital few" defaults not only triggered the collapse of the U.S. housing bubble, they also triggered the implosion of the entire global debt bubble. Here's the basis of the critical 4%: the Pareto principle ("the 80/20" rule) can be further distilled down to a 4/64 rule:
If the parameters in the Pareto distribution are suitably chosen, then one would have not only 80% of effects coming from 20% of causes, but also 80% of that top 80% of effects coming from 20% of that top 20% of causes, and so on (80% of 80% is 64%; 20% of 20% is 4%, so this implies a "64-4 law").
Pareto was an early-20th century Italian economist who noted that 80% of the land in Italy was owned by 20% of the populace. The principle is that 20% constitute a "vital few" who exercise outsized influence on the remaining 80%. For example, Microsoft noted that by fixing the top 20% of the most reported bugs, 80% of the errors and crashes would be eliminated. This can be further reduced to 4/64--that the 4% "vital few" exert outsized influence on the "trivial many" 64%.
And that brings us to Europe.
Clearly, we are well beyond a mere 4% of the sovereign debt in the Eurozone being impaired. The European Central Bank and the ESEF "rescue fund" have already committed 273 billion euros to bail out the banks which loaned vast sums to the small nations of Greece, Ireland and Portugal.
I have been unable to locate a reliable total of all sovereign debt in the EU, but since Italy alone has 1.9 trillion euros of government debt, 3 trillion seems a reasonable guess for the EU, excluding France and Germany.
If we take 4% of 3 trillion, we get 120 billion euros. Since Greece has at least 160 billion in debt that will default shortly, then we can safely say the 4% threshold will be breached, and a "phase transition" will be triggered.
If we reckon that some percentage of Itay's debt--never mind Spain's--is impaired and will have to be written down, then we can say without hesitation that 20% or more of Europe's sovereign debt will soon be recognized as in default or severely impaired.
That 20% will then produce outsized effects on the remaining 80%, collapsing the entire system and the EU's attempts at a grand bailout.
Revisiting the Pareto Principle and U.S. Housing
Not a day goes by that some pundit or analyst doesn't declare that the U.S. housing market is "turning around," "undervalued," or "a bargain."
Before we accept these glad tidings of joy, let's revisit the Pareto distribution of the U.S. housing market's key sector: jumbo mortgages.
Since jumbo mortgages exceed Fannie Mae and FHA loan guarantees, then lenders must accept a higher level of risk in originating jumbo loans. That means they only underwrite jumbos to the most creditworthy borrowers. Thus the jumbo mortgage market is the creme de la creme of the U.S. mortgage market.
So what can we conclude is going to happen to the housing market now that 18% of all jumbo mortgages are in default, and fully half the owners are underwater, i.e. their home is worth less than their jumbo mortgage?
That 18% is close to the Pareto "magic 20%." When we consider that the first 4% of subprime mortgages cascaded into a default rate which now exceeds 40%, then we have to wonder what the consequences will be as 20% of the "last best" mortgages default.
According to the Wall Street Journal--The Index Tracking Credit-Worthy Borrowers Is on the Decline-- the PrimeX index has dropped 5% in a mere month as volume has spiked. This is clearly evidence that "smart money" is exiting the index, anticipating a much steeper drop in the future. According to the WSJ, hedge funds are actively shorting the index.
If the smart money is betting on further declines in the creditworthiness and value of jumbo mortgages, then that suggests another leg down is coming in the U.S. housing market as the top tier crumbles.
My own sense is the entire real estate market is holding its breath, hoping that nobody drops prices any lower. But sales are slow to non-existent in many markets--prices appear stable, but few are buying. It wouldn't take much for buying to dry up and prices to take another "phase shift" down.
The left and right coast markets are still over-valued by historical metrics; an additional 20% drop would still not return prices to pre-bubble levels. Recall that typical default rates are around 1-2%; at 18%, the jumbo mortgage default rate is extraordinarily high. This suggests the "high end" of the housing market that has been resilient to date is about to lose its resiliency and retrace to the mean, i.e. 1998 valuations.
The Sense of Confluence
Despite a stock market that continues levitating on the merest mists of "positive" rumors spun by the perma-bullish financial media, there is definitely a feeling of confluence in the air, as if the bankruptcy of MF Global, the debt implosions in Europe and the property bubble bursting China are swirling into a self-reinforcing confluence that will be greater than the sum of its parts.
What event will crystallize this confluence? According to chaos theory and Nassim Taleb, the proximate cause can be almost anything; the system itself is so unstable that any one grain of sand could cause the sandpile to collapse. It feels like the sandpile is ready to crumble. Perhaps the critical grain of sand will drop between November 14 and December 16.
From Left Field
U.S. home prices down 4.1% in Sept: CoreLogic--that "bargain" just got cheaper
That's how I got in this closet: amusing, slightly risque short video (it's French, what do you expect?)
via Chad D.
via Chad D.
This isn't true.
Swimming Naked in China:
With the Chinese government tightening credit, the massive leakage from the formal banking
Thanks for reading--
Charles
