It’s bad enough that nobodies like me criticize the Fed, but what do you do when members of the FOMC criticize?? Two hawks, Lacker and Plosser, criticize the recent efforts to alleviate difficulties in the lending markets because of the potential for moral hazard.? In this case, moral hazard means to banks: “Don’t worry about bad lending as a group.? If you make mistakes, the Fed will rescue you.”
Give Bernanke some credit, because unlike Greenspan, he lets the members of the FOMC speak their minds.? Hopefully the disagreement will sharpen the Fed, and not lead to paralysis or confusion.? For more background on the individuals who are part of the FOMC, please refer to my piece, A Social View of the FOMC.
I agree the the moral hazard is a live issue here.? The real question is whether growing weakness in the lending markets can be tolerated, which might be worse than moral hazard.
Much, but not all of the upset in the lending markets (which, if you look at swap spreads, the current manifestation of the crisis seems to be passing — down 4 basis points today), is from deflating values in housing. My estimate for how much further real estate has to decline on average in the US is 10-20%. We need to find owners for about 4% of the US housing stock that is vacant. The pain that has been felt in subprime and Alt-A loans will get felt in prime loans, and possibly conforming loans as well. Fannie and Freddie won’t get killed, but they will take credit losses.
So, listen to Cody. Residential real estate markets do not clear as rapidly as a futures exchange. The illiquidity and variations in lending standards tends to lead to markets that adjust slowly, and autocorrelatedly. I.e., if it went up last period, odds are it will go up next period, and vice-versa.
It will take a while for the residential real estate market to clear. When the inventory gets down to 3% it will be time to start speculating on homebuilders and mortgage lenders again, but real estate prices won’t start rising in aggregate until the inventory of unsold homes gets below 1.5-2.0%.
Position: none
Well, the chickens are now coming home to roost.? Residential real estate values have fallen enough that it has eaten through much of the equity of prime borrowers, leading to distress on prime mortgage collateral.? If that is not bad enough, the banks are also staring down falling commercial property prices.? Even Fed Governor Kohn is telling us to expect more loan losses, which I expect will cause monetary policy to be confused amid rising inflation.
At present, the fall in housing prices may be self-reinforcing, as lower prices make more homeowners marginal, and with a negative life event (unemployment, divorce, disease, disaster, disability), they can no longer afford their property.? Prime mortgages are no exception here, particularly if bought near the peak of the recent real estate craze.
Just be aware that the fall in housing prices will take a while to work out.? It may cause larger financial institutions to fail.? But eventually, there will be a bottom that can be bought, perhaps in 2009-2010.? Until then real estate related financials will remain under pressure, and some with concentrated interests, like the mortgage insurers, will die.
Even if Ambac and MBIA (the holding companies) survive, the business that used to be profitable for them will be occupied by others. I’ll throw this out as my next prediction in this space: they both go into conservation, and in runoff, claimants get paid off, senior debtholders get nicked, subordinated debtholders lose a lot, and the equity is a zonk.
One last note: the stocks rally after the downgrade. Probably short covering and other derivative-related activity, but you have to admit it is amazing for the stock to go up when the franchise gets destroyed.
Position: none
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Okay, after yesterday’s piece, there was a fast, opportunistic reaction by S&P. Moody’s action gave them cover to downgrade, and S&P took the ball and ran with it. Now that action gives Moody’s the cover to downgrade freely. There is no longer any reason for them to stay at Aaa. There is no money in it, and their reputation can only take further his from here. Rating agencies are like wolf packs — there is safety in the pack. Don’t be an outsider.
From one of my old RealMoney pieces (12/1/2004): Many of the conflict-of-interest problems still exist today. One more example: Could the ratings agencies downgrade MBIA (MBI:NYSE) or Ambac (ABK:NYSE) even if they wanted to? MBIA and Ambac rely on their Aaa/AAA ratings to the degree that they would have a difficult time operating without the rating. Much of the bond market relies on enhancement from MBIA and Ambac. The loss of a Aaa/AAA rating would be a jolt to the guaranteed bonds.
In addition, MBIA and Ambac structure their risks according to models provided by the ratings agencies. It is the models of the ratings agencies that tell the guarantors how much equity must stand in front of the debt that is being guaranteed. The ratings agencies are an inherent part of the business model of the financial guarantors. MBIA and Ambac can’t get along without them.
The ratings agencies derive so much income from these major financial guarantors that their own financial well-being would be affected by a downgrade. I’m not saying that either should be rated less than Aaa/AAA, but there is a cliff here, and I am wary of investing near cliffs.
Well, we came to the cliff, and S&P shoved MBIA and Ambac to the edge. Now Moody’s can push them over the edge. It should come soon. As with the rating agencies actions on the other financial guarantors, once a guarantor is pushed below AAA, the rating no longer matters as much. There are dedicated “AAA only” investors that care about this, and they will be forced sellers now, or, they will modify their investment guidelines. 🙁
Now, as I have mentioned before, stable value funds will have their difficulties here. Some have positioned themselves as “AAA only” funds, and that led to large holdings of MBIA- and Ambac-guaranteed debt. What they do now is beyond me. I suspect they try to modify their investment guidelines. 🙁
Well, at this point, we have to contemplate life without the old guarantors. They will shrink and disappear, while new guarantors, who are all currently skeptical of doing much more than Municipal bond insurance, will grow, and make it impossible for the old guarantors to return, because they are much better capitalized. Once you lose your AAA as a guarantor, you will rarely get it back.
