Saturday, March 22, 2008

Desperate central bankers to bail out MBS market?

(Naked Capitalism) I quoted Lucy Kellaway, who once said (apropos management fads), "No idea is too ridiculous to be put into practice," and warned that the credit crisis would soon get that sort of treatment.

A story in the Financial Times indicated we are getting closer to that stage:
Central banks on both sides of the Atlantic are actively engaged in discussions about the feasibility of mass purchases of mortgage-backed securities as a possible solution to the credit crisis.

Such a move would involve the use of public funds to shore up the market in a key financial instrument and restore confidence by ending the current vicious circle of forced sales, falling prices and weakening balance sheets.

The Fed apparently called Greg Ip at the Wall Street Journal to quash this leak, um, rumor (hat tip Calculated Risk) but don't be surprised if it rears its ugly head in a few months.

Nevertheless, this is a curious and appallingly naive characterization of the problem. Yes, we are seeing credit contraction, and it isn't pretty. But the deleveraging isn't the result of a negative feedback loop operating in a vacuum; it's that a lot of mortgage borrowers cannot make their payments, and their number will increase over the next few years to to ARM resets. And because prices in most markets had risen to levels that were way out of line with incomes, there are simply not even remotely enough people who could afford to buy the houses undergoing defaults at the prices at which they had been financed.

There seems to be a collective fantasy at work, that somehow the powers that be can wave magic wands and turn bad assets into good ones. While you can do that on a small scale, we have a roughly $20 trillion residential housing market that is being repriced for good reason. We've gone on about this ad nauseum; a fresh statement of the underlying problem comes from Bill Fleckenstein in "Catering to the Balioiut Nation" (hat tip Nattering Naybob):
Where will all this stop? Can those who behaved prudently afford to bail out those who behaved imprudently? Why should they have to? And is that what we really want? After all, this country's median income of roughly $49,000 can hardly be expected to service the debt of the median home price of $234,000, up from approximately $160,000 in 2000.

Let's do a little math. Forty-nine thousand dollars in yearly income leaves approximately $35,000 in after-tax dollars. Call it $3,000 a month. A 30-year, fixed-rate mortgage would cost approximately $1,500 per month. That leaves only $1,500 a month for a family to pay for everything else! (Of course, in many communities the math is even less tenable.) This is the crux of the problem, and the government cannot fix it.

Housing prices, thanks to the bubble and inflation, have risen well past the point where the median (or typical middle-class) family can afford them. Either income must rise -- which seems unlikely on an inflated-adjusted basis -- or home prices must come down.

And if that didn't convince you, have a look at this (click to enlarge):


Even coordinated government action cannot prop up asset prices when the underlying cash flow isn't there. Japan tried that, and they had the advantage of having very high domestic savings. The Home Owners Loan Corporation of the Great Depression's results are not comparable to our current situation. First, it was not implemented till 1933, so the weakest borrowers had already lost their homes. Second, mortgages were structured differently then than now: much shorter terms (15 year was the usual limit) and vastly loan to value ratios (50% was the max, and of course, paydowns would reduce that amount). HOLC refinanced these into 30 year mortgages. Thus even with large housing price declines, the HOLC in the vast majority of cases was issuing loans against homes that still had equity.

Conversely, the damage of letting housing fall to a market clearing level appears to be overstated, and the lack of empirical investigation into the results of housing busts in other advanced economies is a major lapse. This comes from a post last August:
Let's look at what has happened in other countries that had large declines in real estate prices.

The housing recession of the early 1990s was far worse overseas.....
In the late 1980s and early 1990s, the United Kingdom, Finland, Norway, and Sweden experienced peak to trough falls in prices of greater than 25 per cent. Sharper falls have been observed in some South and East Asian economies over the 1990s, particularly in Hong Kong and Japan.

....yet despite Gross invoking the specter of the Depression, these economies suffered only short, nasty recessions. UK GDP fell 2.5% in 1991 and 0.5% in 1992.. According to NATO, Finland had a steeper fall because its contraction was caused by economic overheating, depressed foreign markets, and the dismantling of the barter system between Finland and the former Soviet Union under which Soviet oil and gas had been exchanged for Finnish manufactured goods. Thus its fall in housing prices was more a consequence than a cause of its recession. Sweden similarly suffered from disruption of its trade relationship with the former USSR. Hong Kong has enjoyed high growth and volatile real estate prices, but the only year it had negative GDP growth was 1998, the year after its reunification with the mainland, when it suffered a major capital flight.

So while these economies all have different structures than the US, their experience nevertheless suggests that even severe housing recessions do not inflict long-term damage. I'd very much like to hear the views of those who have studied the international record more deeply, but this quick survey suggests the price of a housing recession is a sharp but short-lived real economy contraction.

Another problem with the "let's just go buy the mortgages" line of thinking is a propensity to rely on models rather than empiricism. With all due respect to Paul Krugman, who came to the right conclusion in his post, his analysis seems to have encouraged some other economists (witness this post from Brad De Long, whose analysis is mainly sound) who are trying to restore the bubble equilibrium (point H on Krugman's chart):
But in the current situation, a lot of securities are held by market players who have leveraged themselves up. When prices fall beyond a certain point, they get calls from Mr. Margin, and have to sell off some of their holdings to meet those calls. The result can be a stretch of the demand curve that’s sloped the “wrong way”: falling prices actually reduce demand. So the market could look like this:

Krugman has the right insight: H exists only by virtue of leverage. He continued:
Implicitly, Fed policy seems to be based on the view that if only they can restore confidence — with extra liquidity to the banks, Fed fund rate cuts, whatever — they can get us out of L and back to H. That’s the LTCM model: Rubin and Greenspan met a crisis with a rate cut and a show of confidence, and the whole thing went away.

But at this point a series of rate cuts and other stuff just hasn’t done the trick — which suggests that maybe there isn’t a high-price equilibrium out there at all. Maybe the underlying losses in housing and elsewhere are sufficiently large that the situation really looks like this:


And in that case, the Fed can’t rescue the financial markets. All it — and the feds in general — can do is to try to limit the effects of financial crisis on the rest of the economy.

Let's consider another complicating factor: that just about every effort to ameliorate the credit crisis has merely produced problems elsewhere. The "let's just buy the mortgages" advocates forget that the sharp rise in Freddie and Fannie spreads that kicked off the latest round of deleveraging didn't come out of a clear sky, It was a negative market reaction to the increase in the mortgage ceilings on the GSEs in combination of making them the refinancer of crappy mortgages. That would be enough to spook any investor. In a post earlier this week, we went thougt a list of unintended consequences (a more accurate term would have been backfires) of the Fed's efforts to date. Reader Lune ventured what might happen next:
Now we have 3) Fed opens TSLF to broker-dealers. Given the track record of our esteemed Fed so far, I shudder to think what the unintended consequences of this one will be, and I'm disturbed that it's very likely that no one has thought about that while running around in a panic shooting from the hip at any shadow that comes up. Anyway, here's my speculation...

The Fed is already close to tapping its full balance sheet. The trigger for the collapse of the past few weeks has been the rise of agency spreads, which is the cause not the effect of all the implosions we've seen so far. So to stop the panic, the Fed would have to intervene in the agency market. But it's remaining reserves of ~$400bil is tiny compared to the amount of debt out there. Furthermore, even a full faith govt. guarantee is unlikely to stop the rise in premiums (witness Ginnie Mae debt, where spreads are increasing even with a govt. guarantee). This is partially because of panic, and partially because agency debt will have fundamentally different behavior when it includes all the extra debt Congress is talking about stuffing it with. So with that uncertainty and unpredictability, it's no wonder spreads are increasing.

As the spreads continue to claim more casualties, more firms will line up for funding (when do hedge funds get to drink directly from the punch bowl? At this rate, probably in a week or two), and the Fed, unable to say no, will have to start issuing treasuries to expand its balance sheet. Within a matter of a month or two, the Fed will find itself with a trillion or so dollars of impaired debt in a "repo" that can't ever be recalled (some because the counterparty's balance sheet is still too weak, others because the counterparty has gone BK). The ultimate casualty? The Fed itself, unable to lower interest rates below 0%, facing default on collateral on its hands, and counterparties (central banks) unwilling to trust the Fed to manage the dollar any longer.

Oh yeah, and mortgage markets will still be frozen.

We are unlikely to see a bottom to the housing market for quite a while (historical precedents suggest early 2011) and that solvency problems have to work there way through the system. If we must have rescue operations, I would much prefer something along the lines suggested by Robert Reich:
The next question is how to cushion the blow for middle and lower-income people who might lose their homes or their jobs, cars, medical insurance, and large chunks of their pensions. This may require federally-subsidized insurance -- mortgage insurance so homeowners can meet payments, along with expanded unemployment insurance, health insurance, maybe even pension insurance. All hard to accomplish, but ultimately more important than bailing out the big banks.

I will admit to not having thought this idea through, but the intent of policy should be to limit damage to individuals rather than intervene in asset market in ways that are destined to fail anyhow. After all, isn't all this hooplah to prevent a recession? And I thought recessions were bad because they increased unemployment (oh yes, and lower corporate profits too). Maybe it's time to recognize that a recession is unavoidable, and that the efforts to contain it are producing serious side effects that are at least as bad as the problem they are intended to solve. And that's just looking at the immediate impact; this becomes a net negative effort when the Fed's credibility is irreparably damaged (and we are just about there).

The one bit of good news: the FT article made clear that any rescue program was not going to come into being any time soon, and that was before the Fed's denial.

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