Going back to bank stress-testing for a moment, one interesting thing that a Treasury official said at the meeting was that unemployment did not have a big effect on foreclosures. Unemployment has a big effect on credit card defaults, but not foreclosures. I disagree.
As a multi-purpose quant, I have learned over the years that it is impossible to estimate an option curve/function when the variable in question has only been “in the money” or “out of the money.” (As an example, one can’t estimate the withdrawal function on deferred annuities because haven’t had a large sustained rise in interest rates since the product was created.) With mortgage debt, over the last 70 years, real estate values have never fallen enough to make default a reasonable choice until now. Thus in the past, when unemployment hit, one could sell, rather than default. As I have said before, foreclosure typically occurs when someone is inverted on their mortgage, and a life event happens: death, divorce, disability, disaster, disemployment, change in financing terms, or deciding that it is worthless (and doing a strategic default).
But now residential real estate values have fallen. When someone loses their job, the option to default becomes real. Do a short sale, and give the bank a hit.
With stress-testing, the devil is in the details. How do you turn unemployment, housing prices, etc., into losses tailored for each individual company? Different underwriting standards can make quite a difference in the results. I would have been more than happy to dig through detailed stress testing models. That was my job once.
When the Treasury announced the stress-testing results, it was at a time when the gloom was thick. It was a positive to the market that the government would not require huge amounts of extra capital, and in most cases, no extra capital. Thus the market rallied.
With many simple asset classes that were under stress, the Fed and Treasury offered guarantees that would enable them to easily survive the panic. Absent the guarantees, most short assets would have been “money good,” but there would have been significant doubt for a brief time.
As I commented to a Treasury staffer after the meeting, with financing rates so cheap to buy financial debts, regardless of what kind, it is no surprise that corporate bond spreads have tightened, while there is still little lending to finance growth in the real economy. That is why there is such a gap between Wall Street and Main Street.
Main Street sees unemployment and low capacity utilization. Wall Street looks at bond spreads and P/Es. Those are not the same things. The current stimulus has emphasized healing the financial sector in an effort to avoid contagion and depression. It does not directly address slack in the real economy. The real economy funds the bailout of financials, but does not directly benefit. Thus the disconnect between Main Street and Wall Street.
Many financial measures and companies have rebounded, but little expansion has occurred in the real economy. Even with companies that have done bond offerings, they have often used the proceeds to bolster the balance sheet, rather than expand capacity. Safety first is the watchword.
Perhaps a change happens when companies with a lot of cash appear as takeover targets in a sluggish market. Easier to grow market share through acquisition rather than organically, and what’s better, their cash helps pay for the deal.
It seems that the low end of the housing market has bottomed. Government programs have something to do with it. The tax credit has made a difference in the short run, as has the efforts of the Fed to support the mortgage markets through the purchase of RMBS.
Mortgage modifications are advertised by the Treasury, but the results are small. Away from that, I will say that successful modifications occur more likely when there is some degree of principal forgiveness.
Tonight, I will pick up on the risks of low interest rates in part 4.
Who was Invited?
I’ve been in touch with staffers at the Treasury. One of them gave me a list of the invitees. Here is the list of those invited that did not come:
Free Exchange at The Economist
The Audit at Columbia Journalism Review
If you were in the Treasury’s shoes, who else would you have invited? E-mail me, or put it in the comments. Tomorrow I will mention who I thought would have been good additional guests.
Here is a list of posts to date on the meeting:
Friday in Vegas (Kid Dynamite):
“A Sit Down With Senior Treasury Officials – Part I”
“Curious Meeting at Treasury Department”
Across the Curve:
“Bond Market Open November 04 2009”
“Financial Regulation: How Would You Have It Work?”
Treasury Officials Meet With Financial Bloggers
Sympathy for the Treasury
That’s all for now. Until this evening and part 4.