Real Estate and Mortgages – Page 34

Eight Notes and Comments on the Current Crisis

Posted on 27 October 200827 October 2008 by David Merkel

1) Greenspan — what a waste.? A bright, engaging man becomes a slave to the Washington political establishment.? Now he gives us a lame apology, when he should be apologizing for his conduct of monetary policy, which encouraged parties to take on debt because of the Greenspan Put.? Now the debts are too big to be rescued by the Bernanke/Paulson Put, where the Government finances dodgy debts.

On a related note, Gretchen Morgenstern is right when she calls the apologies hypocritical.? I would only add that Congress also needs to apologize; they did not do oversight of the Administration properly.? Many members of the oversight committees are not economically literate enough to do their jobs; they can only score political points.

2) I found this post highly gratifying, because it points out the disconnect between macroeconomics and finance, which I have been writing about for years.? When I was an economics grad student, I felt economics had gone astray by trying to apply statistics/mathematics to areas that could not be precisely measured.? In this case, if your models of macroeconomics can’t accommodate the boom/bust cycle, you don’t deserve to be an economist.

3) You want accounting reform?? Start with accounting that disallows gains-on-sale in a financial context.? WIth modern life insurance products, gain from sale is not allowed under SFAS 97, and I would modify SFAS 60 to be the same way.? No profits at sale.? Profits are earned in a level way over the life of the business as risk decreases.? Let other financial firms use something akin to SFAS 97, and many business problems would be solved.

4) What freaks me out about this article is that Taiwan is refusing the full faith and credit of the US Government, which stands behind GNMA securities.? Don’t bite the hand that feeds you; who knows but that you might be traded for the elimination of Kim Jong Il.

5) It figures that the moment the PBGC buys the specious arguments of a pension consultant that the equity markets crash.? Whaat makes it worse is that the PBGC tended to buy long Treasury debt which has been one of the few securities rallying? recently.

Given all the furor over investing in long duration bonds for pensions versus equities, it is funny that the PBGC rejected the growing conventional wisdom that DB plans should invest in safe long bonds.? Once they reject their current pose, the equity market could rally.

6) Is the economy weak?? Well, look at the states.? If their tax receipts are going down, so is the economy.? We are in a recession, and maybe a depression, given the lack of strength in the banks.

7) Do we need a new system for managing the global economy?? The Chinese certainly think so.? They finance the US and don’t get much in return.? Perhaps China could host the new global reserve currency?? I don’t think so.? Their banking system isn’t real yet, and they still want to subsidize their exports.? The global reserve currency role will flow to the largest economy allowing free flow of capital.? Now, who is that?? Japan?? Too small, but the world now recognizes that their banks may be in better shape than many other countries.? Plus, they have been through this sort of crisis for a while, and may be closer to the end of it than the rest of us.? The alternative is that Japanese policymakers still don’t have the vaguest idea of what to do, much like the rest of the world now.

Thing is, we don’t have a logical alternative to the US Dollar as the global reserve currency.? The Euro is a creation of an alliance of nations untested by economic crisis.? Perhaps the rest of the world should consider the possibility of no global reserve currency, or keep the US Dollar, or, move to a commodity standard like gold or oil.

For now, though currencies will follow the path of panic, as carry trades unwind, as countries that had too much borrowing see loans repaid (Japan, Switzerland), and countries with high interest rates see a demand for liquidity, which perversely will push rates higher.? (Isn’t everything perverse in the bust phase, just as everything is virtuous in the boom phase?)

8 ) On the bright side, some boats are rising.? After seeming irrelevant, the IMF has found a reason to exist again with loans to Iceland, Hungary, and Ukraine, with more to come.? The small/emerging markets once again learn that they were at the end of the line in this economic game of “crack the whip.”? That said, the developed market banks financing them will get whipped too.? This is truly a global crisis.

And given that it is a global crisis, I wonder how willing the developed nations will be to add more funds into the IMF when they have crises at home to deal with?? I’m skeptical, as usual.? Perhaps the Treasury can send them a raft of T-bills.? The IMF can ask the Fed for contact info.

(more to come)

NOT Born and Bred in the Briar Patch

Posted on 24 October 2008 by David Merkel

Originally, I was not a fan of Bernanke, but the more I read about him, the more I liked him.? Still, my main fear that I wrote about at RealMoney at the time of his nomination has largely been realized in my mind.

		David Merkel
		Why I Don’t Like Bernanke as Fed Chairman
		10/24/2005 12:09 PM EDT

From my post on April 4th:

“I’m not crazy about Ben Bernanke being selected chairman of the Bush administration’s Council of Economic Advisers. This is not because I think he’ll do a bad job there; odds are, he’ll do fine. It’s kind of a nothing job, anyway. I just suspect that this is a stepping stone to becoming the next Fed chairman. Bernanke is too much of a dove on inflation for me, and too seemingly certain of his own opinions. If we have very placid economic conditions, he could do fine as Fed chairman. If we have crisis conditions, the last thing I want is a dovish idealist as Fed chairman.”

Greenspan was more of a political operative than an academic, and as such, fairly pragmatic as he threw liquidity at every crisis, creating a climate of moral hazard. Investors lose fear of loss, because monetary policy will bail them out in a crisis.

Academics think they understand how monetary policy affects the economy, and in my opinion, have a higher degree of confidence in their views than say, a banker in a similar position would. When models of the world are imperfect, a false certainty can do a lot of damage. Bernanke is a bright guy, but bright doesn’t mean right.

Position: None

Bernanke spent a lot of time studying the Great Depression as a grad student, and I did not.? As an academic, there is the bias that says, “Yes, but we have learned from the past, and know what to do next time.? We have the game plan to fight Depression II set.”

I think the wrong lessons were learned by Dr. Bernanke, and many academic macroeconomists.? They look at the ineffective remedies at the time: negative monetary growth, Smoot-Hawley, and lack of stimulus, and they conclude that if they can stimulate a lot more, they can avoid Depression II.

Depressions occur because market actors take on too much debt, including financial institutions, and at the tipping point, cash flow proves insufficient to service the debt, starting a self-reinforcing bust cycle going the opposite direction of the prior self-reinforcing boom.? Once the self-reinforcing bust starts, I’m sorry, but there is little that can be done.? Liquidation of bad debts must happen to clear the system.? In the absence of that, we can have a Japan-style scenario where rates go to zero, and we stay in a funk, or we could inflate the mess away, harming savers and pensioners.

The boom-bust cycle is normal to Capitalism and should be enjoyed, rather than avoided by policymakers.? A lot of smaller busts are better than one big bust when national debt to GDP levels are at record levels.

At this point, stimulus merely slows down the inevitable.? We aren’t liquidating debts as much as transferring them to the government.

I am waiting for the first Treasury auction failure.? They won’t call it a failure, and they may reschedule it.? When that happens, we will have a statement that shifting private debts to the US Government is not appreciated by the creditors of the government.

We also could have semi-failures, where the market clearing rate at the auction is well above the average bid.? A few of those, and the yield curve could be at record wide levels.

I view the Federal Reserve and Treasury as being a bunch of amateurs here.? That’s not an insult.? Take me, James Grant, or any number of bright critics of the Fed and Treasury, and if they were in charge now, they would be amateurs also.? There is nothing in their training that prepares them for dealing with the credit equivalent of nuclear winter.? Nor should there be.? These abnormal periods happen every 40-80 years whether we like it or not, once we forget the lessons of building up too much leverage under a fiat money system.

Should they be blamed for not bailing out Lehman?? That was the inflection point for this crisis as it is manifesting now.? Yes and no.? Yes, since they took it upon themselves to be the guardians of the whole financial system.? Yes, since they bailed out Bear and AIG, two institutions that they had no business bailing out.? Both were bailed out for reasons relating to systemic risk, and both were politically unpopular.? But though Lehman may have posed less systemic risk than AIG, it certainly posed more risk than Bear.? Yes, because they jolted expectations.? No, because they couldn’t have known the full chain of events that allowing Lehman to fail would touch off.

A hidden cost here is that activism begets more activism, or, at least, a demand for more activism.? If the Federal Government and the Fed are now the lenders of first resort, it is no surprise that many will come-a-beggin’.? Once you are willing to lend to support one critical area of the economy, my but many areas will deem themselves critical as well.? Where does it stop?? At this point, I think it might have been better to let Bear, Fannie, Freddie, and AIG fail, but with some sort of expedited bankruptcy process that quickly disposes of equity rights, and converts all debt claims into varying degrees of new equity.? This extinguishes debt claims, and accelerates the healing of the economy.? This would be true reform.

Looking Forward

Now, suppose for a moment that the monetary and fiscal stimulus programs work in the short-run, and bring down rates.? What happens when the Fed tries to exit?? My guess is that they can’t exit.? In paying interest on reserves, the Fed is slowly replacing the Fed funds market with its own lending.? If the Fed leaves, the crisis reappears.? But even apart from that, the government ends up with more debt, and that has to be serviced in some way.

In providing guarantees to money market funds, buying top-rated CP, and helping financial firms finance paper of varying quality, the Fed replaces markets that ceased to function for a time.? The Fed sets yields and prices for credit, but with little to guide their decisionmaking.? Set the price too high, and there are few takers.? Too low, and there are many takers.? Beyond that, with so many programs, what is a bureaucrat to do to figure out which programs are offering the most relief?? I’ll tell you, it is not possible to figure that out.? The money going out is certain, but the benefits are not.

Now, as Greenspan mumbles, wondering about how this crisis could have come about, those of us that are more aware (or intellectually honest), look at the increase in total debt levels and say, “It’s pretty amazing that the system held together for so long.”? It’s an ugly situation, but it is worth asking whether the current actions of our government might harm the future well-being of our nation.

It’s almost never a good idea to sacrifice freedom for security.? But the Federal Reserve has done that.? They are now tied to the Treasury Department, and any policy independence they had is gone.? Book-smart Bernanke has been co-opted by the street-smart Paulson.? Bernanke is a bright guy, but he was not “Born and bred in the briar patch,” as was Paulson, who learned the ropes on Wall Street.? (Do I have to say that Wall Street produces harder characters than academia?? No?? Good.)

In this case though, we are beyond normal, even for seasoned veterans of Wall Street.? There are no comparables any more.? This is more severe per unit time than 1973-4 or 2000-2.? Only the Great Depression remains as a benchmark, and that era grins at us as we think we can beat the process of delevering through government action, of which they had much.

I’m not grinning here.? We are looking at tough times.? May the Lord help us.

When What Cannot Happen Happens, More Surprises Likely Await

Posted on 24 October 200824 October 2008 by David Merkel

After not feeling well for a few days, I am back to writing.? Let me start with a blast from the past from RealMoney, during happier times:

		David Merkel
		Swap Curve Inverts a Teensy Bit, for a Moment
		2/17/2006 12:29 PM EST

Nothing big here, but the swap curve briefly inverted twos to tens a few minutes ago. There is no reason to panic here; I’m just pointing out something that is highly unusual in the bond market. Having successfully traded bonds 2001-2003, I can say that strangeness tends to beget more strangeness. If this inversion gets larger and persists, I will have a post on the topic, but for now, this is just a curiosity.

Position: none, but the swap market affects us all in a wide number of quiet ways…

		David Merkel
		The Deepening Inversion
		2/22/2006 11:06 AM EST

I did not expect the inversion in the Treasury curve to get so deep so quickly. At present, the Treasury curve is inverted 15 basis points from twos to tens. Does this mean the market is falling apart? No, only the economics of spread-based lenders.

Whoever taught me (way back when) that the swap curve can’t invert deserves a few whips with a wet noodle. It’s small, but swaps are inverted two basis points twos to tens. What will I see next? Inverted corporate curves for BBB bonds? I can’t imagine what that would imply for the economy. It would deepen my feeling that we are in uncharted waters in a low nominal world.

On the CPI, it is an advantage for TIPS buyers that the bond market focuses on the core CPI, when TIPS buyers get paid off of the unadjusted CPI. It allows us to get more yield off of our TIPS.

Inflation is higher than the core CPI indicates for a wide number of reasons, but the simplest one is that they exclude food and energy, whose prices have risen at faster than everything else for the past 10-20 years.

Eventually the long end of the Treasury curve will react badly when market players revise their long run inflation expectations, which in my opinion are too low. But for now, international flows dominate because US yields are higher than those in most other countries, and pension fund flows dominate because of a need to fund long liabilities. Until those factors quit, we will continue to live in a weird bond market, with uncertain implications for GDP and the equity markets as a whole.

This doesn’t make me change any of my strategies yet, but it does leave me uneasy.

Position: long long-dated TIPS, bank floating rate loan funds

Back then the yield craze was upon us, and credit risk forgotten.? The swap curve was theoretically never supposed to invert on a yield basis.? That was then, this is now.? A new yield craze is upon us, where credit risk is omnipresent, even in securities of the highest quality.? It reads, “I don’t care about the yield, just give me guarantees for a long time, and keep me safe.

That is manifesting in (at least) three ways right now:

Failure to deliver in repurchase markets. (Alea, Jesse’s Cafe Americain)
Swap spreads going negative on the long end of the curve. (Across the Curve, FT)
What bond deals are getting done for investment grade names are getting done at amazing spread levels.? (Baker Hughes, Pepsi — in 2002, spread levels for single-A names never got this wide, though some cyclical BBBs got that wide.)

The grab for safety is relentless, and the efforts of our Government are small relative to the size of the economy.? The yields of the investment grade bond market are a truer measure of the troubles, because no one is fiddling with it yet.? Even so, the fiddling may not turn even the manipulated markets around.

PS — As a final note, a kind word for the CDS market — their netting procedures work admirably, as pointed out by Alea (numerous times), and Derivative Dribble (a valiant start for a new blog).? Here’s a wild thought: we need the same thing on a broader and more complex scale, allocating the embedded losses in our financial system to their rightful recipients, wiping out common, preferred equity, and subordinated debt as needed, and forcing the conversion of debt claims to equity, delevering the system in a colossal way.

CDS netting does that in a flash for synthetic debt exposures, but how do you do it for a wide number of assets at once?? I’m not sure it can be done.? My question is this: do the present actions of policymakers genuinely help, as they shift debts from private to public hands, or do they merely delay the inevitable?? I hope the former, but I think it is the latter.

Full disclosure: long PEP

Picking Some Stocks to Survive the Market

Posted on 18 October 200819 October 2008 by David Merkel

I have not done well in the markets for the last six weeks.? Here is why:

Overweight in Life Insurers.? Yes, they are in better shape than the banks, but that only means they got hit later, not that they would not get hit.
Too much economic sensitivity.? I felt that global demand would hold up better than US demand, but that only means they got hit later, not that they would not get hit.
I suspect that hedge funds have been blowing out my positions.

I’ve ben talking about stock survivability lately.? What does that mean?

Low levels of short-term debt.? Few major debt maturities coming in the next three years.
Low levels of total debt relative to tangible capital.
Still earning money and producing free cash flow, even in a tough environment.
If a company is cyclical, it has slack assets, particularly cash equivalents.? High current and quick ratios.
If not a financial, trading at a historically low price to sales ratio.? If a financial, trading at a historically low price to book ratio.
Good accounting quality and corporate governance.
A leader in their industry.? It would be difficult to lose them.

With a little work on my side, I came up with 80+ names to consider, that I think fit the above criteria, mainly:

AAPL ABX ADBE ADP AFG AHL ALL APA AXS BBOX BHE BHI BHP BWA CAS CB CF CHV CINF CLF CMI CRH CSL CTSH EBAY ENH FCX FDS FSR GD GPC GWW HANS HAR HCC HMN HON IBM ITW LNT LOW MHP MMM MRO MSFT MTW NKE NOC NOV NUE NVDA ODP OKE ORCL OXY PC PEP PL PRE PTP RE RHHBY RIO ROC ROCK RTN SHLM SIGI SYK T TEX TMO TRV TYC UTR VCLK WAG WBC WDC WRB Y ZMH

This is a portfolio that I think will do well even in tough environments.? I will be buying some of them on Monday, and let you know what I did.

Blame Game III

Posted on 18 October 200819 October 2008 by David Merkel

I went on a shopping trip today to buy a desk for my two youngest children (10, 6), both girls.? As I drove, I listened to radio C-Span, because it is “guilt week” for the NPR stations in the area.? In hindsight, I would have rather listened to the begging from the NPR affiliates than what I heard on C-Span.

The program that I heard was hearings on the financial crisis.? All of the testimony fell into the bucket of “not me, there are evil people who tricked us.”? My daughters must have found my negative commentary to be funny.

We have the government that we deserve.? Congress listens to self-interested loonies, rather than seek out those with intelligence that don’t have an axe to grind.? When I wrote the pieces, Blame Game, and Blame Game, Redux, what I tried to express is that there are a lot of parties to blame in our current crisis, and that everyone should ‘fess up their culpability.

With that, I want to add on a few more responsible parties:

29) FICO srcoring enabled loan underwriting to decouple from the local bank investigating the character of the borrower.? There is something lost when the underwriter does not explore the qualitative aspects of the borrower.

30) The fools who wrote that said that it is easy to make money in stocks or real estate.? They always show up near the end of the cycle.

31) Dojo suggests the Prime Brokers — How about the Prime Brokerage business model followed by most banks and investment banks which allowed their speculative clients to go ?nuclear? in any marketplace as long as they had a credit facility and a cell phone. A $10 million hedge fund run out of a basement in Westchester County NY or Orange County CA could control $1 Billion worth of goodies in many cases. Yikes!! A bit severe, but there is some validity there.

32) dlr suggests the FDIC — The bank regulators at the FDIC. It was their JOB to maintain oversight of the banking industry. Every regulator who allowed the banks they were monitoring to giving liar loans, or pick a rate loans, or zero down payment loans, and didn?t call a halt, should be fired for malfeasance. The regulators who had oversight of Washington Mutual and Indy Mac should be fired. And their BOSSES should be fired. Right up to Shiela [sic] Blair. I think that all of the banking regulators deserve blame here, plus the Bush administration, who encouraged malign neglect.

My main point is this: if you are defending your core constituency in this crisis, you are at least partially wrong.? There are so many culpable parties, that few are blameless.

Final note: in many ways, this is a proper comeuppance to US policy that encourages home ownership.? Policy was trying to push home ownership to 70%+, when reality should have said “be happy with a stable 60%.”? Home ownership is not an unmitigated good.? Many cannot truly afford it, and the government tricks them into buying what they cannot afford with reasonable probability.

Debt and Sweat

Posted on 14 October 2008 by David Merkel

Ordinarily, when I sit down top blog, I know what I want to write.? That’s not true now.? Yes, I could do a few book reviews.? I have six books read, and ready to go, but given the volatility of the markets, I feel I have to say something about the current activity.

I am a strong believer that there are few free lunches.? If there are simple policies that will easily produce prosperity, they would likely have been done by now.

As I have commented before, what we are seeing now is a shift in debt from the banks to the government.? Banks get capital, the government gets debt, and the money for the debt comes from three places: taxpayers, foreign lenders (central banks, probably) and perhaps at some point, the Federal Reserve could buy it (whether they monetize it or not is another question).? As jck noted yesterday, this has led to a selloff in Treasuries.? (Interesting that it happened on a day when the cash markets were closed, but the futures markets were open.? The reaction of cash bond market today is similar to that which the futures market exprerienced yesterday.)

Which brings me to my first point.? Today, when the rally in the fixed income markets gets reported (the markets again, were closed yesterday, you will likely hear that spreads rallied sharply.? But watch for the discussion of yields and prices (if there is any).? It’s quite possible that yields rise from Friday to the close of business today.

Second point, today $250 billion of the $700 billion got used on nine big/critical banks.? Now, this may have been somewhat coercive to some of the nine banks; as was said at Bloomberg:

None of banks getting government money was given a choice about it, said one of the people familiar with the plans. All of the banks involved will have to submit to compensation restrictions, said the person.

The government will also guarantee the banks’ newly issued senior unsecured debt, making it easier for them to refinance their liabilities, the person said.

Possibly the following message was delivered, “Be a good boy and get in line.? This is good for the nation, and we won’t be around for a decade.? You want to be a survivor, right?? You want friendly regulators when we review the levels at which you are marking your illiquid assets?? We thought so.? Sign here.”? (No surprise that Goldman then applies for a NY State, rather than Federal bank charter.? State regulation, particularly when you are a local champion, is much more flexible.? Just ask AIG. 😉 )

Though this leads to a short-term bounce in bank share prices, the long term effects are less clear, which brings me to my third point.? It’s one thing to bolster their balance sheets.? It is another to get them to lend, particularly in the bear phase of the credit cycle.? Also, as leverage comes down, and it will come down, so will profitability at the investment banks, and probably other banks as well.? Securitization will be less common, eliminating hidden leverage that allowed for less capital.

The same thing is going on in Europe, though they actually think about how they might pay for the bailouts.? In the UK, it pushes the national debt to GDP ratio to 100%.? As it gets closer to 150%, the international debt markets usually start to choke.? We have traded bank credit risk for national solvency risk at the margin.? Maybe that will be different here, if only government creditworthiness is perceived to be safe.? It is a “new era,” right? 🙁

I find it interesting that Barclays is refusing help.? Either the UK regulators aren’t so coercive as those in the US, or Barclays is not as levered as I thought.? Or, it could be hubris on the part of Barclays’ management team.

Even Japan is getting into the act, though these measures seem so weak that I wonder why they would bother.? The government and Bank of Japan stop selling bank shares, and allow companies to buy shares back more aggressively.? That may push share prices up in the short run, but it substitutes debt for equity, which shouldn’t have much of a long-term impact.

On the Central Banking Front

Now, with the seemingly limitless amount of US liquidity being to the short end of the US money markets, you would think that we would get a bigger move than we have gotten so far. This will take time, but watch the yield as well as the spread.? Also remember that LIBOR has become somewhat of a fiction at present.? There many quotes, but not so many loans to validate the quotes.

What is being done that is new?

TAF expanded to $900 billion.
New commerical paper program where the Fed backstops the A-1/P-1/F1 CP market, including ABCP.? Terms here.? FAQ here.? This is big, and it is much easier to start such a program than to end it.? It is difficult to end any program where credit is granted on less than commercial terms.? My guess is that it will be extended past its April 30th, 2009 planned expiry date.
Swap agreements allowing unlimited dollar liquidity to foreign entities through agreements with their central banks.
The Fed can now pay interest on reserve balances held at the Fed, which allows them to increase their balance sheet significantly.? In one sense, they become the Fed funds market.

What is not new is the idea that all we have to do is restore confidence, and everything will be fine.? No, we have to delever, and the US Gowernment is included in the list of those that need to delever.? There is no national reform going on here, but merely a shifting of obligations from private to public hands.

For investors:

For those that are investors, the biggest bounces tend to occur during depressionary conditions.? I would not get overly excited about the rally yesterday.? As John Authers at the FT points out, given the extreme changes being made, there should have been a bounce.? The question is whether it will persist.? I was a net seller into the rally toward the end of the day.? I think we have more troubles ahead.? Two things to watch:

LIBOR, CP yields and the TED spread. (The short end)
Overall yields of medium-to-long Treasuries and other long-dated debt.? (The long end.)

I expect yields to rise, even if some spread relationships fall.? The added financing needed by the US government is large.? Let us see where Treasury buyers have interest.

There are elements of this that remind me of my The US Dollar and the Five Stages of Grieving piece. This is for two reasons: first, we are asking foreign entities to hold more dollar claims at a time when they are stuffed full of them.? Second, this phase of the credit crisis reminds me of the “bargaining” phase of the five stages of grieving.? We are past a long denial phase, and the anger continues, but now we bargain that these proposals will allow us to escape the pain that comes from delevering.

I’m skeptical, but I hope that I am wrong, lest we get to the fourth stage “depression,” before we finally reach “acceptance.”? As it is, I am looking for companies with blaance sheets strong enough to survive the worst.? That is my task for the next few days.

Blame Game

Posted on 10 October 200810 October 2008 by David Merkel

Some people don’t like the concept of blame.? They view it as useless because it wastes time in looking for a solution.? I will tell you differently.? Blame is useful because it identifies offenders, which is the first step in eliminating the problem.? The trouble is that few have the stomach to get rid of the offenders.

So, as I traveled home from prayer meeting with my children last night, we listened to a radio show discussing the current credit crisis.? This was a good discussion, unlike many that I hear.? But the discussion (on NPR) eventually focused on “who should we blame?”? Okay, here is my incomplete version of who we should blame:

1) The Federal Reserve, especially Alan Greenspan.? For the past 20 years, we couldn’t let the economy have a severe, much less a moderate recession.? Rates were reduced before significant pain was felt by those who had borrowed too much.? The 1% Fed funds rate in 2003 was the pinnacle of that effort.? It created the ultimate bubble; there is nothing left to reflate in 2008 from easy monetary policy.

2) Congress and the Presidency — they encouraged undue leverage in a variety of ways:

a) Fannie, Freddie, the FHLB, and more: Everyone has gotta live in a single family home.? Gotta do that.? Thomas Jefferson’s ideal was that we should encumber future generations so that marginal buyers could live in houses beyond their means.? They compromised lending standards more and more, along with private lenders as the boom went on.

b) The SEC: in a fiat currency world, controlling the currency means controlling leverage of financial institutions.? The SEC waived leverage restrictions on the investment banks in 2004, leading to a boom, and a bust. Big bust.? Ginormous bust — how many large standalone investment banks are left?

c) Particularly the Democrats in Congress defended the GSEs as their own pet project.? I am not bashing the CRA here; I am bashing the goal of having everyone live in a house beyond their means.

d) We offered a tax deduction on mortgage interest, and a limited exemption on capital gains from selling a home.? There is no good reason for these measures.

e) And, the Republicans in Congress who favored deregulation in areas for which it was foolish to deregulate.? Much as I favor deregulation, you can’t do it if you have fiat money (unbacked paper money).? In that case you must restrain the growth of credit.

f) The Bush Jr. Administration — they did not enforce regulations over financial institutions the way that the law would demand on a fair reading.? Again, I’m not crazy about regulation, but unless you have a gold standard, or something like it, you have to regulate the issuance of credit.

g) Their unfunded programs with promises to the future; the states and Federal Government always promise today, and don’t fund it.? Hucksters.

3) Lenders steered borrowers to bad loans.? There was often implicit fraud, and in some cases, fraud.? The lenders paid their staff to do it.

4) Borrowers were lazy and greedy.? What? You’re going to enter into a transaction many times your income or net worth, and you haven’t engaged helpers or friends to advise you?? Regardless of the housing price mania, you should have gone slower, and done more homework.? Caveat emptor — you neglected that.

5) Appraisers were slaves of the lenders who wanted to originate and sell.

6) Those that originated MBS did not check the creditworthiness adequately.? They just sold it away.? Investment banks did not care where a profit was coming from in the short run.

7) Servicers did not demand a high price for their services, making it hard for them to service anything but solvent borrowers.

8) Realtors steered people into buying more than they could rationally afford; I’m not saying they did that on purpose, but their nature was to sell to get the highest commissions.

9) Mortgage insurers and financial guarantee insurers — because of the laxness of accounting rules, they were able to offer guarantees significantly in excess of what they could pay in the deepest crisis.

10) Hedge funds, investment banks and their investors — they demanded returns that were higher than what was sustainable.? They entered into businesses that would not survive difficult times.

11) Regulators let themselves be compromised by those following the profit motive.? Many hoped to make money after joining private industry later.

12) America.? We let ourselves become short-term as a culture, encouraging short-term prosperity, regardless of the cost.

13) Neomercantilists — they lent us money, because they wanted they export sectors to grow for political reasons.? This made our interest rates too low, encouraging overinvestment and overconsumption.

14) Average people who voted in Congress, and demanded perpetual prosperity — face it, we elect those that govern us, and there is the tendency in America to love the representative that brings home the pork, while hating Congress as a whole.? Also, we need to bear with recessions, and let them do their work, and not force our government to deal with them.

15) Auditors that did a cursory job auditing financial entities.? As the boom went on, standards got lower.

16) Academics who encouraged a naive view of diversification, and their followers who believe in uncorrelated returns.? In a bad economy, everything is correlated, and your statistics from a good economy don’t matter.

17) Pension and other funds that believed the academics.? It is amazing what institutional investors will fund, given the mistaken idea that correlation coefficients are stable.? Capitalistic economies are unstable by nature!? Why should we expect certain strategies to workallo the time?

18) Governmental entities that happily expanded government programs as the boom went on.? Now they are talking about increased taxes, rather than eliminating programs that are of marginal value to society.? Governments should not rely on increased taxes from capital gains, or real estate tax assessments.

19) Those that twitted “doom-and-gloomers,” and investors who only cared if markets went up.? It is hard to write about what could go wrong in the markets.? Many call you a wet blanket, spoiling their fun, and alleging that you are a short, or some sort of misanthrope.? The system is biased in favor of happy talk.? Just watch CNBC.

20) Me, and others who warned about the current crisis. Perhaps we weren’t clear enough.? Maybe our financial interests made us look like we were talking our books.? I know that I spent a lot of time on these issues, but in the short run, I was still an investor, trying to make money in the markets, hoping that what I feared would not occur.? Now I am getting my just desserts.

This is an incomplete list.? I invite you to add others to the list in your comments.

Industries Don’t Learn From Each Other on Credit Issues

Posted on 8 October 2008 by David Merkel

As usual, my friend Caroline Baum wrote another good piece on the credit crisis called Anatomy of Crisis Starts With Skewed Incentives.? I want to take her idea, and run with it a little, because the insurance industry has faced similar problems.

In the P&C insurance industry, there has often been the problem of “giving away the pen.”? For those not familiar, that means letting someone else make the underwriting decision, while you accept the policy onto your books.? Why might a company do that?? Simple — they see opportunity in some neglected market where an experienced Managing General Agent says he has a program that is very effective.? Unfortunately in the old days, the MGA would get compensated on sales, and modestly on underwriting results.? As Caroline put it: skewed incentives.

Anytime you offer significant money for sales without some significant underwriting check, you are asking for trouble.? The agents will write all that they can.? One of my greatest successes in business was designing a compensation formula for pension representatives that aligned their incentives with the company’s profitability.? Worked well for four years, and that was a lifetime in this business.

On another level, we can consider the issue of credit triggers.? Credit triggers are designed to deal with small issues, not large ones.? Anytime credit triggers can be so big as to bring a company down, the company should refuse to enter into such a course of business.? But where have we seen this before?

Life Insurers with fixed rate GICs (early 90s)
Life Insurers with floating rate GICs (late 90s)
Utilities in the early 2000s (think Enron-like structures)
P/C reinsurers in the early-to-mid 2000s

With respect to the last of those, the representative from S&P and I lectured the World Insurance Forum in Bermuda in 2004 that it would not work.? Sadly, a few companies had to fail because no one changed.

Both AIG and Lehman went down because of capital calls from derivative agreements.? Anytime one puts a clause onto an agreement where more capital has to be posted on a downgrade, it sets up a cliff, and wise companies don’t set up the cliff.? Normal companies stay away from the cliff.? Dumb companies get pushed over the cliff, and complain about shorts before the failure, and creditors after the failure.

Our current credit crisis boils down to two factors: excessive leverage, and lousy underwriting standards.? Those resulted from a system that rewarded mortgage origination without much adjustment for credit quality.? Now we suffer for it, while bad debts get liquidated, or inflated away.

Entering the Endgame for Monetary Policy, Part II

Posted on 8 October 2008 by David Merkel

Here’s my updated graph of the composition of the Fed’s balance sheet, with modifications as suggested by some of my readers:

As you can see, the percentage of the Fed’s balance sheet containing Treasuries, whether held for itself, or together with the government is declining.? Let’s look at it another way that contains some editorializing by me:

By lower quality assets, I simply mean assets less creditworthy than the US Government or its agencies.? That’s an estimate on my part.? Why does balance sheet quality at the Fed matter?? If the Fed wants to extend credit, it can more easily do so by having higher quality assets, like Treasuries.? Now, the Fed can lose money, and it means that seniorage profits that go to the US Treasury get reduced, or go negative, which implies increased borrowing or taxation.

I can’t remember which Greek philosopher said something like, “Democracy is doomed when people learn that they can vote to get money for themselves from the public treasury.”? I know Tyler and de Tocqueville said something like that as well.? At a time like this there are a lot of demands on the public treasury, and they are growing:

There is a trouble here.? In the absence of a functioning market, how can the bureaucrats at the Fed figure out the right prices/yields to charge?? This is the same problem as valuing level 3 assets, but without a profit motive to aid in focusing the efforts of the businessman.

Now, the little graph above (from The Economist) describes the real cause of the problems.? As in the Great Depression, there was too much debt financing of assets.? The debt was more liquid than the assets, as well.? Borrow short, lend long.? Oh, and remember, the graph above does not contain the hidden debts of the Federal Government (Medicare, Social Security, and old unfunded DB plans), the states (low funded DB plans and unfunded retiree medical plans), and corporations (poorly funded DB plans).? Nor does it take account of the synthetic leverage from derivatives.

What we are seeing at present is not a reduction of the debt structure of the economy, but a shift from public to private hands.? That can lead to four results, when the debt of the US Treasury is so large that it cannot be serviced:

Inflation when the Fed monetizes the debt,
Depression from vastly increased taxes,
Debt repudiation (whether internal, external, or both), or
Japan-style malaise for a long time.

Japan-style malaise is sounding pretty good. ;)? No growth for several decades while the government debt bloats, and financial balance sheets slowly normalize.? Trouble is, we don’t internally fund our debts.? At some point, our creditors will tire of throwing good money after bad, and then the next cycle can begin in earnest, when the neomercantilistic nations give up, and accept that their investments in the US are worth a lot less than they had thought, and allow their currencies to come to a fairer level against the US dollar.

Financial intermediation has limits.? Financial and economic systems function better at lower levels of leverage if you want it to be sustainable.? Granted, you can have big boom phases if you pile on the leverage, but they will be followed by big bust phases, where the deleveraging is painful.

All of the government’s/Fed’s choices are bad here.? Dr. Bernanke is on a hopeless task, and his theories, borne out his academic studies of the Great Depression, means that we will get a new sort of Great Depression.? There is no easy solution; it is merely a situation where we choose which poison we want to take while the deleveraging goes on.? My guess is that we see some combination of malaise plus inflation.

As Martina McBride said in her song “Love’s the Only House,” “Yeah, the pain’s gotta go someplace.”? The pain is going somewhere; our policymakers are merely determining where.

PS — I am by nature a moderate optimist.? I invest in equities, and many of my sub-theories of the world, i.e., how well will the life insurance business fare, and how well will global demand fare versus that of the US, are being tested now, and I am finding myself the loser on both counts.? Yeah, the pain’s gotta go someplace

Oppose the Current Bailout Plan, Redux

Posted on 1 October 2008 by David Merkel

Perhaps the tide is turning.? Congress is now receiving more calls in favor of the bailout? Ugh.? People are so attuned to short term market moves defining what is right or wrong.? They would surrender their liberties just to make the markets rise.? Well, the Senate votes on Wednesday evening, and the House probably on Thursday, so I urge my readers, and the rest of the blogosphere to call Congress to oppose the Bailout.

Now, the current plan is better than the original one, having more oversight, and requiring equity stakes.? I still don’t like the proposal, because it won’t work on the areas of our economy that need help now, mainly the short term lending markets between banks.

As it is, the pressure in those markets is high, and the Fed is stretching its balance sheet to cope.? Other nations and central banks are acting to stem the panic, and are moving to support the short-term lending markets.

This is a global crisis, with rates rising in Asia, with failing banks in Europe, and the rescue of AIG protecting the interests of European banks, as well as domestic institutions.? The other nations of the world should step up to their responsibilities; we are all in this together.? If not, we will probably experience a global recession lasting two or more years.

Not that anything is certain in economics; the global economy has been straining over the last few years to goose growth in ways that seem foolish to me.? We know the lessons of mercantilism.? Why force exports when the returns may prove to be far less than advertised?? China may laugh over a growing economy where they sell an increasing amount to the US, but what are they receiving in return but devaluing US T-notes?

Look, there is a better bailout available.? Aim at the short term lending markets; use the $700 billion to recapitalize the Fed, and let them provide liquidity until the short-term lending markets calm down.

Or, use the money to take super-senior convertible stakes in financial institutions that are in trouble.? If the government is bailing institutions out, let them do it in a way that minimizes loss, that they would have a senior creditor position if there is loss, and significant ownership if there is a recovery.

With that, I close by saying don’t listen to foolish people who say that we can make money off of the bailout.? The objective of a bailout is to lose less money than you expected.? There are rare cases where money is made, but as we would expect with government intervention in tough times, the incentives are perverse.