Thursday, November 06, 2008

I'm taking an awful risk here... this had better work...

Is the TARP working? Are rate cuts working? Stimulus package? Is the TSLF working? What about the GSE conservatorship? Is that going to work? What about my lucky rabbits foot?


Pundits love to debate whether any given program will "work" or not. But in these debates, the participants tend to talk past each other. Take the capital injections made through the TARP. One side can argue that this scheme is "working" because of falling LIBOR and CDS spreads on banks. The other side can claim that this program does nothing to address the root problem (foreclosures) and will not allow the U.S. to avoid recession.


Of course, they're both right. And hence this is a boring and frankly unproductive debate.


Most of the programs and plans currently enacted (my rabbit's foot aside) are aimed not at preventing a recession. That ship has sailed. To see what I mean, think about the basics of the business cycle.


Recessions tend to be the result of some misallocation of resources within the economy. Since reallocating resources takes time, there is an inevitable period where the economy operates at less than full capacity. The greater the adjustment needed, the deeper and longer the recession.


In the period leading up to this recession, we had a overinvestment in housing. Even if nothing else had happened, the adjustment in housing probably would have resulted in a recession. Loans were made that shouldn't have been made. Houses were built that shouldn't have been built. We need to clear the excess investment (houses).


However, we also had a financial economy which had become reliant on low volatility and continuous access to liquidity. After the failure of Bear Stearns, Wall Street was forced to decrease their leverage positions. Continuously falling marks, especially on housing assets, only increased their need for additional equity. This added to the already painful economic adjustment underway.


The came September. The rapid failure of the GSEs, Lehman, AIG, Washington Mutual and Wachovia changed everything. The urgency for firms to deleverage was dialed up to 11. In addition, common forms of debt financing, including securitization, have completely dried up. Most firms can fund their activities using other forms of financing, but it will be expensive and potentially painful to make the transition.

So now we need to adjust to a large number of foreclosures, a deleveraging financial system, and a rapidly changing funding structure. That is a recipe for a deep and long recession.

There is nothing the Fed or anyone else can do to prevent this process from occurring.

But the Fed and Treasury can help to ease the transition. Programs like the commercial paper funding facility can help firms that relied on asset-backed commercial paper to transition to other secured funding. Offering FDIC insurance on new bank debt allows banks to roll-over maturing debt, buying them time to deleverage through normal cash flow.

But these programs cannot, will not, and I content were never intended to "fix" the financial system. We will get through this, but we need more time.

As an investor, if you continue to think in terms of "solutions" from the government, you are missing the point. Even putting my libertarian ideology aside, the government cannot "solve" a misallocation of resources. The best thing it can do is provide liquidity to make the transition as painless as possible.

So in thinking about whether some scheme is going to "work" or not, think in terms of avoiding unnecessary economic adjustments. Think in terms of easing the transition. Don't think in terms of avoiding a recession or reversing the steep losses in the stock market. Nothing can stop that now.

15 comments:

Don said...

"Recessions tend to be the result of some misallocation of resources within the economy."

One thing that might be useful is an explanation of how this occurred. What causes this misallocation?

Don the libertarian Democrat

you said...

Misallocation occurs whenever you are able to allocate funds towards things you do not need.

Accrued Interest said...

Yeah I think in this case we had a period of time where we legitimately needed more housing stock, but it over shot. The fact that Wall Street fell in love with financing housing allowed the overshoot to go way beyond where it would have otherwise.

I'd say without the CDO market, the overshoot on housing would have been minor.

Josh Kalish said...

1. Great post, the scary thing is that few political leaders understand the situation. (eg: "Why aren't the banks lending more!!?" )

2. Remember the overallocation had a government source as well. By using 5t of balance sheet to buy or wrap us mortgages the GSE's helped bid up properties beyond reason. Just imagine how art would be bid up if your had the GSE's in there buying up 1/3-1/5 of all art.

gingersue said...

Back in the dot-com bubble, we had misallocation of capital towards fiber optic cable (dark fiber probably still not lit yet) and internet businesses to eliminate the middleman. A business plan of selling individual heavy bags of dog food over the internet was a misallocation of capital.

lineup32 said...

years of low interest rates combined with massive leveraged credit creation generated surprise:
inflated assets!
Overproduction of housing, auto's,
RV's planes, boats, and the entire range of designer lifestyle assets is based on easy credit and fits with the worlds automated manufacturing outlook which has little to do with filling society.

Don said...

Would you say that a similar misallocation occurred in the 1980's prior to the S & L Crisis? What role do you believe that implicit and explicit government guarantees to intervene in a financial crisis played in this misallocation?

In other words, the cause was a series of discrete bad loans made by lenders. What incentives caused this? What caused the willful neglect of risk and lowering of standards, beyond simply trying to make money, which occurs in all profit transactions?

If my question doesn't interest you, leave it?

Don the libertarian Democrat

PNL4LYFE said...

Good post. I wonder what the new Congress/Administration will do when they realize that all this money is not going to prevent the deleveraging and falling prices of all assets. Will it be another round of rebate checks? Perhaps some wasteful infrastructure projects? I'm anxious to see how our tax dollars (or more accurately, our grandchildren's tax dollars) will be wasted.

Flow5 said...

Even if mortgage paper is mark-to-market now, or later, or until maturity, it's value is likely to be lower (because housing prices ballooned)

Shouldn't the rules be changed to accelerate this transition?

Flow5 said...

And I don't see why this paper can't be valued. There are Ph.D's in credit management. Credit scoring can be set up for the receivables.

Can't the mortgages be sorted by zip code & since housing prices are monitored by region, an average decline in prices can be assumed, etc., etc.

PNL4LYFE said...

Flow: all those things are being done. The problem is that any estimate of loss requires assumptions which are extremely hard to make with any accuracy. For many of the structured products, very small changes in assumptions make the difference between par and total loss. For the vanilla mortgages, the prices can be estimated more accurately, but the massive face value turns small price differences into huge dollar amounts.

If it can be said that there is a "market view" on mortgage securities, I think the majority of people believe that eventual losses on mortgages will be lower than what market prices are implying. However, that view is based on a view of how the economic slowdown will affect the eventual trough in house prices. Until house prices begin to stabilize, it's impossible to estimate losses with any confidence.

Ryan said...

Great post... artificially low interest rates led to a general overinvestment in assets financed by leverage. Without managed interest rates... no housing bubble. The moment the government intervenes, it causes malinvestment... such misallocation of resources causes capitalism to break down.

Accrued Interest said...

Thanks for all the kind words.

Couple responses... first, to Flow5, there are many mortgage-oriented assets where the mark-to-market price is a good deal lower than the estimated actual credit losses. So at least for firms that need to mark-to-market, and are doing it honestly, their marks are already below the price you are suggesting.

So that means that either:

1) The market is wrong.

2) The loss estimates are wrong.

3) Risk premia have risen substantially, and therefore M2M losses reflect more than just expected credit losses.

The blogosphere likes #2 in a landslide, but #3 makes way more sense. #3 is consistent with everything else that's going on in the fixed income markets.

PNL notes that until home prices stabilize there is always a chance that losses continue to rise beyond anyone's current estimations. That is exactly what I mean when I say the risk premia are rising, even if the base estimation for losses isn't. Am I making sense?

Its clear that a number of factors helped spurn on housing investment. But I think the Fed's low interest rates in 2002-2003 were a minor factor in hindsight. I really think the rise of the CDO was the major factor in pushing housing from over-valued into bubble territory.

Wriiight said...

The Fed's low interest rates were part of the cause of the rise of the CDO. The markets were starving for any manner of asset with AAA-rating and yields that beat out treasuries. So the mortgage banks shoveled up anything they could find to sell out to that market 'cause heck, if you subordinate anything enough it is bound to get to AAA.

The rising house prices also resulted in historically low foreclosure rates, so those that projected the future based on recent history saw great returns even on the crap. Most banks did not spend nearly the effort predicting loss that they did predicting prepayment because prepayment projections actually had a larger effect on yield than even (gasp) tripling loss estimates!

By the way, GSEs still haven't received a dime of federal money, and TARP hasn't bought any loans from banks.

Lockstep said...

Great Post. Great insight.