I’ve talked about the troubles in our economy stemming from asset-liability mismatch. Too many people/institutions financed risk assets:
- With inadequate equity (provision for adverse deviation)
- With lending terms that were much shorter than that of the assets financed
- Where the borrowing terms can shift against the borrower in an adverse economic environment. Think of borrowing in a harder currency, or loans that can reset of recast with payments going higher.
- Where lending terms could be modified by third parties. Think of the rating agencies downgrading a company and it has to put up more assets as collateral.
Another way to say it is too many relied on the ability to refinance on favorable terms. But now that favorable terms are no longer there, we live in a time of broken balance sheets. What were some of the classic examples of this phenomenon?
- Buying houses with little money down.
- Buying houses where the terms can reset against you. Houses are long term assets, and must be funded with a generous amount of equity, and long term financing as far as the debt is concerned.
- Hedge funds bought long duration assets, stocks and longer bonds, when their capital bases could be withdrawn at much shorter intervals.
- Many mergers were done for cash near the peak of the product pricing cycle for their particular industry. The debts incurred hang around, but funny, the pricing power doesn’t when demand collapses.
- Many companies invested in new productive capacity – energy, agriculture, mining, just as the global economic cycle was peaking. Others in developing markets had ramped up industrial capacity beyond the world’s capability to absorb it.
- Defined benefit pension liabilities were increased by states and municipalities which relied on the idea that tax revenues would grow indefinitely at a rate of 4-5% or more. The same for corporations that assumed 7-10% asset returns for the next 50 or so years.
- Even 10-year commercial mortgages with 30-year amortization presumed on the ability to refinance 10 years out. Was there the possibility that ten years out, refinancing terms would be worse than at origination? Yes, and we are there now.
In any case, there was often a mismatch as the global economy grew during the boom phase. New long term assets were created, and financed with not enough equity, and debt terms that were shorter than the life of the assets.
Much of this can be laid at the doors of the Central banks of our world, because they pulled out all of the stops in the early 2000s to help establish an unending prosperity. News flash: the boom/bust cycle is endemic to mankind; efforts to eliminate it merely create a version with long shallow booms and big busts. Eventually the piper must be paid; there are no free lunches. The easing of monetary policy 2001-2003 led to one final big bout of risk taking 2003-2007. We are living with the aftermath now, as the central banks do everything to try to reflate with no success. When consumers have little capacity to increase indebtedness, monetary policy is useless, leaving aside helicopter tactics.
So what can the government do at a point like this, since they are committed to permanent prosperity?
- Inflate, raising the nominal value of collateral. This is the simplest solution, and the Fed resists it. It would also force the other governments of the world to go along.
- Provide long-term financing to troubled corporations, whether through long debt, equity, or hybrid instruments.
- Bail out states and municipalities with burdensome pension liabilities.
(NB: I am not saying the government should do any of these things. I am simply saying that these are better than what the government is currently doing.)
Government funding is short duration by nature because of the annual appropriations process, and lack of any restraint – little in the way of rainy day funds – a presumption of prosperity in budgeting. Few governmental entities in the US assume that receipts will be lower in future years. Budgets are often made assuming that spending will increase, and that taxes will rise to fill the gap. Well, no more of that, at least for a while.
Any scheme that relies on increasing prosperity is inherently mismatched. No tree grows to the sky, and that includes nations and their governments. There is a natural process where nations are born, grow, mature, decay, and die, unless some event intervenes to revivify the nation, giving it new purpose and energy. With the US over the last 75 years, there has been slow decay amid prosperity. Payment for obligations is pushed out into the future, because growth will solve our funding crises. Government debt covers a multitude of sins, in the intermediate-term.
Financing the Economy at Treasury Interest Rates
When I hear talk that the government should borrow to fund mortgages, or dodgy companies, I cringe. I hear things like: “These assets are at depressed levels because of a lack of confidence. The government can borrow and buy them, and make a profit on the spread, particularly after confidence resumes.” “Let the government absorb Fannie and Freddie and make loans at affordable rates to people. They can provide mortgages much cheaper than the private sector.” “The value of the assets of AIG is artificially depressed. The government can finance those assets and sell them for a profit when confidence reappears.”
The borrowing capacity of the US Government is limited. I don’t know what the limit is – which straw will finally break the back of the camel, but there is a limit. The borrowing capacity of our government should be used to its best effect, and playing as a bank or a hedge fund is likely not the right answer.
An overage of private and public leverage pushed asset prices above their equilibrium levels. Residential housing is a good example here. Prices still need to come down to restore the affordability levels that existed through the second half of the 20th century. The Fed could inflate some of the problems away, but that does not seem to be on their menu of choices at present.
I have seen private residential mortgage bonds trading at levels where I said, “The odds of these not being money good are remote.” Yet, the bonds trade (if they trade) below 70. (100 is being paid in full.)
This is because there are fewer entities capable of holding the bonds to anything near maturity. When someone complains to me about the price of a mortgage bond, after analysis, I often say to find an entity that is willing to hold the bond to maturity, or slightly less, and they can garner full value. But anyone holding that bond that can’t hold it to maturity, or doesn’t want to, is merely a speculator.
We developed too many speculators in the 2000s, and not enough parties that would hold assets to maturity. We now suffer for that, including our dear government. Our dear government is like Brer Rabbit punching the Tar Baby, but without the advantage of being born and bred in the briar patch. They don’t know what they are doing. They have some vague idea about what Keynes said, but don’t understand the limitations of his theory. Bernanke is the expert on the Great Depression, so whatever he suggests in this context must be right? Right?!
Sadly, no. To the extent that private sector debts are not reduced, the crisis does not end. Even the swapping of private for government debt is merely a “delay of game” strategy, because there will be a greater crisis when the US Government cannot service its debts. We live in a period of waning prosperity, with the US Government having decreasing ability to influence events.
At present, absent inflation for the Fed, the broken balance sheets of our world imply a slow recovery, where any earnings go to fill in balance sheet holes, and buy up broken competitors. It’s not a fun environment, but it is an environment where good managements can pursue relative advantage if they are careful. Guard your liquidity carefully, and persevere through this tough time.