Friday, August 31, 2007

I don't like this...

I wrote extensively in the last couple weeks about the liquidity crisis, and made the case for Fed easing. See here and here. I got a lot of arguments from commenters that the Fed would somehow be bailing out someone by cutting now, thus creating a moral hazard problem (see this post as well as comments in previous links).

Then the Fed picked an option I didn't consider. Hell, I don't know anyone who did consider it. And I believe it was truly a stroke of genius. They tried to use the discount window to provide liquidity where it was needed (banks) but not where it wasn't (thus fueling inflation.)

Notice what was particularly genius about the discount window idea. Nobody really was getting bailed out. Therefore, in my not so humble opinion, no moral hazard issue. See the under capitalized mortgage originator who spent the last two years pumping out no-doc loans didn't get squat from the Fed. Hedge funds who leveraged the hell out of sub-prime MBS portfolios didn't get squat from the Fed. But the bank who might be hurting to find liquidity for a relatively benign ABCP program has an outlet to get short-term cash. No bank runs, but no bail out either.

I'll say this about the concept of moral hazard. As a parent, the idea is something you deal with all the time. If your kid does something wrong, there has to be consequences. If you tell your kid not to play with his food or he'll be punished, you have to follow through. Otherwise he'll assume that your threat of punishment is meaningless and you'll lose all control over his behavior.

Its the same thing with banks making bad loans. We can't simply have the government make the bank whole when a loan goes bad, because then the bank wouldn't have any incentive to do good credit work. In fact, the bank would be incented to just make as many loans as possible, with no regard for quality.

In my view, the discount window lending, or even Fed cuts, would not cause a moral hazard problem. I say this because I believe that individuals make decisions, not institutions. The individuals at New Century are all out of work. The guys running the BSAM hedge funds are all out of work. Its not like they are at home sitting on their couches watching CNBC and thanking the maker for wider use of the discount window.

And frankly, the suffering of others in the past doesn't seem to prevent the same basic mistakes in the future. Take the infamous Long-Term Capital Management. That fund sunk solely because it had too much leverage and couldn't withstand a short-term liquidity crunch. Sound like any stories you've heard lately?

So now to today's news that the Bush Administration wants to literally bail out some delinquent borrowers. I really don't like this move at all. I know what's currently being announced is limited in nature, but what they are proposing is to have FHA step in and insure timely payment of mortgage loans which are currently delinquent. I fear that Congress will move to expand programs of this sort. Now I think you are really sending the wrong signal to underwriters. To me this is exactly like threatening to send your kid to his room without dinner, then sneaking some pizza up there 10 minutes later.

Apparently the FHA proposal involves some 80,000 loans, which doesn't amount to much of anything. So maybe this is all just politics, if the program doesn't grow in scope. But I'm suspicious it will be growing. And I think this is just plain bad policy.


Anonymous said...

I'm curious, TDDG:

In your mind, is there any cost to the Fed injecting liquidity by reducing target Fed Funds?

Or is it a costless solution? A free lunch, if you will.

And also, is there a level of costless rate cuts; say, 25-50bps?

Its interesting to me because this seems to be the consensus view -- I've heard, today, at least six prominent economists at Jackson Hole say that the Fed should cut 25-50bp. Not one mentioned a single downside to these cuts.

How wonderful that the solution to our economic problems can be achieved with such ease (no pun intended).

Anonymous said...

For all Americans who were prudent in financing the purchase of a house, the President's announcement was a slap in their faces. A free market system requires NO bailouts of investment mistakes. Once the virginity of the free market system is lost, it can never be restored. President Bush will be remembered for many things, sadly none of which will be good.

Anonymous said...

Then the Fed picked an option I didn't consider
Not just one option ...
Correct me if I'm wrong, but there seem to be different (a little easier) collateral requirements at the Discount Window than for overnight Open Market Repos and Reverse-Repos.

Further, the System Open Market Account (SOMA) can lend securities from its account. Collateral requirements for those loans seem to be the easiest (not that I can figure out whether the interest charged for loan of those securities is even "penal" or not).

have FHA step in and insure timely payment of mortgage loans which are currently delinquent
Look on the bright side. If the Administration's implementation achieves the same level of competence of its past, I have no reason to worry about my Bond Index Fund investment.

As the head of an Administration which will be trying to sell high-priced Treasuries to the bond market for the forseeable future, it does seem a strange thing to say. How do the Administration and Congress think programs like this get paid for?

@tddg Please reassure a small investor that, when the Treasury Dept. announces an auction and tells a paid professional like yourself what price you're gonna pay for their paper, the pistol they're holding to yer punkin' head is a large caliber one.

Anonymous said...

First, I want to point out how absurd it is for all the captains of capitalism to say they need rescuing from a central economic planning authority.

The taxpayer did not share in any of the upside when these 110% LTV, no documentation loans were made -- so why should taxpayers share in the downside? Can you name a single hedge fund, CDO underwriter who is issuing free call options?

If you are smart enough to *deserve* a seven figure paycheck, you should be smart enough to know that long mbs = short gamma. Selling geometrically more gamma just at the point credit spreads were at historical narrows was asking for trouble.

If you don't understand the risk, you shouldn't be trading the product. If you did understand the risk, then what are you whining about?

Consumer debt has exploded in recent years, growing much faster than incomes. The cure for too much leverage is not more leverage.

Anonymous said...


1) I don't know of a single Wall Street analyst who can call the 2y-10y spread correctly three to five years in advance (at least not consistently, anyone might get lucky).

2) Wall Street spends millions of dollars doing credit checks and filling out ISDA agreements before entering swap transactions with customers

... and yet, no one blinked at the idea of selling a subprime borrower a receiver swap -- allowing them to pay floating instead of fixed rates on their mortgage.

Did Wall Street, in effect, say that subprime borrowers are a better credit risk, and are better at calling curve spreads many years in advance?

Agustin said...

Just a quick thought on moral hazard. If the interbank rate trades at a higher level than the Fed funds target, then liquidity injections represent NO moral hazard whatsoever. The Fed is simply playing by well-established & previously communicated rules. Indeed, it is its duty to intervene. Again: no moral hazard!

Nonetheless, the Fed is likely to change the way it conducts monetary policy in the future, avoiding as much as possible episodes of sharp & prolonged discrepancies between market rates and the Fed funds rate (remember the Fed funds rate at 1% for ... months!).

Agustin Mackinlay at the Global Liquidity Blog (

Accrued Interest said...

David P.: The cost is increased inflation, either consumer or asset prices. As far as a level of "costless" rate cuts, that's tough. Many are arguing that money is now de facto tighter than it was 6 months ago, and therefore the Fed needs to cut in order to maintain the same policy stance. So if that's true than cutting to a certain degree just puts us back where we were. The "cost" in terms of marginal increase in money supply would be very low indeed.

I'm sympathetic to that view. However, I think there is a solid case for Fed cuts based on economic growth alone. We're currently below GDP potential, by my estimation.

Accrued Interest said...

Anon #1: I agree. I'm also afraid that congress is going to be more willing to bailout borrowers (voters) than the President is.

Psycho: Well, I understand CP was always eligible as discount window collateral. But yeah, the discount rate was the headline, and with it came a number of alterations to how the discount window would be used. And on top of that were some unusual open market activity.

I think I've only bought like $5 million on auction in my whole career. I just don't like the auctions very much. I'd much rather buy a current bond and know exactly what I'm getting.

Accrued Interest said...

Anon #2: I'm 100% with you. The buyers of poorly constucted ABS/ABS CDO stuff should just whither and die. I'll have absolutely no remorse.

Plus a large number of the home mortgage borrowers who are in trouble now were basically speculating on properties. My understanding is that unofficial estimates suggest that a very large percentage of the liar loans were people buying flip properties. They couldn't afford the mortgage long-term, but they figured they'd sell the damn thing in 2 months anyway for a big profit. So they lied about their income to qualify for the loan. I don't know why I should view this as anything other than a scam.

Now real borrowers who are going to get squeezed by higher interest rates have my sympathy, but that doesn't mean I think anything should be done for them. I mean, I'm sympathetic toward people who lose their jobs in a slide-rule factory too. But that's how capitalism works. Sometimes it sucks, but the good outweighs the bad.

Accrued Interest said...

Anon #3: I think its a case of trusting your models too much. People thought they could predict prepayment/default rates with a reasonable degree of certainty. When in fact, they could not.

Agustin: I agree that the moral hazard argument is way overblown, as I wrote in the post.

Anonymous said...

tddg: What happens to the housing securitization market now that Fannie and Freddie are up against their caps and, as of this morning's announcement, have both avoided issuing their September REMICs because of lowered customer demand?

Anonymous said...

Moral hazard argument is simply not realistic with most subprime borrowers. The only chance to create a moral hazard lies with investors. Most residenital real estate investors are already blown out of the water and all the help I see proposed is only for owner-occupied housing.

The typical first time borrower bought in 2006 because they kept seeing the housing market move further away from them. Many thought that if they didn't do it in '06 they would never get a chance. I hardly beleive that after receiving late payment calls that they will be willing to "stretch" for a house anytime soon.

The moral hazard argument is just not realistic for these buyers. More importantly, unlike an earlier comment, the costs to folks who own a home will be higher if something is not done to lower the number of potential defaults. The higher the level of defaults the less housing will be worth and for those unfortunate to live in neighborhoods with high defaults and vancancies, the social costs will be high indeed.

Lastly, I am not sure why 5.25% on the fed funds rate is the magic number. The housing market began its downturn in the summer of 2005 and assuming that Fed policy works with a lag the Fed stopped the housing party much before 5.25% In fact you could argue the fed was piling on and this after Greenspan sugested people should take out ARMs.

Accrued Interest said...

I think REMICs (another word for CMO) are hard to price right now. I don't think anything is wrong with the CMO market long-term.

I don't view the cap as such a big issue, because I see net mortgage lending being close to flat for a couple years. That means that new mortgages will basically only be created as old mortgages are paid off. So FNMA/FHLMC can hang around their cap without it having a negative impact on the MBS market.

Accrued Interest said...

On moral hazard... I agree with the commenter. The poor lending standards were being driven by securitizations, not by borrowers, in my opinion.

Anonymous said...

The problem is that if you buy the Brooklyn Bridge, you don't get to keep the bridge.

That's what Bush is offering: you were stupid enough to buy the Brooklyn Bridge, but, guess what, you're going to get the bridge anyway.

Sure, there are a ton of evil lenders out there. But the marks can't just walk away with the Brooklyn Bridge.

They shouldn't pay taxes on debt they walked out on, and they shouldn't go to debtor's prison, but they shouldn't get the Brooklyn Bridge either.

It has been suggested that lenders working out a loan is more profitable than letting it default. Yes, of course. But that doesn't really change anything.

Accrued Interest said...

Update: I've read a fair amount about this plan since I posted this, and it now looks like 250,000 or so loans will be impacted. Bear Stearns thinks that this will reduce sub-prime defaults by about 10%, which is HUGE for CDO holders.

Anon: See, a loan modification is mutually agreed upon. In a world where banks held all loans on their sheet, loan mods would really be a matter of how the bank best thinks the delinquency can be worked out. That's totally free market.