Tuesday, March 11, 2008

Markets prefer (petite) brunettes..

It’s one of these days when you wake up in the morning and you think “Finally, I can write the word “sex” on a (strictly!) economics blog and keep my conscience clear!”

That’s thanks to Eliot Spitzer, New York Governor and one of the most “self-righteous” (or “ruthlessly opportunistic,” depending on who you ask) former Attorney Generals for the state of New York. In case you missed the news, Mr. Spitzer was caught paying a four-digit amount for premium sexual services offered by a “pretty petite brunette” in Washington, DC on the eve of Valentine’s day.

(Correction! His sin was not supporting prostitution, nor cheating on his wife… it was the act of “transporting the petite brunette across states” for immoral purposes. Yes, quite tellingly for the nation’s capital, Mr. Spitzer had to pay for a New York call-girl to come over. The rest is history).

Then, a couple of hours into my morning, Ben steps in… and makes the Spitzer affair seem sooo passé. So, I’m sorry to say that, rather than my economic model on morality, I’ll give you my quick take on the Fed’s new measures aimed at restoring liquidity in credit markets:

“Big Deal!”

I hope you sensed the irony there. Because it’s not a big deal. But let me first give a quick and dirty explanation of what’s going on.

So the credit markets have been bleeding, as securities linked to the performance of mortgages (subprime and, gradually, prime) have seen their prices plummeting, causing severe losses to major banks, smaller banks, “shadow” banks and non-bank financial institutions, prompting more forced sales and leading to a downward price spiral.

With the downward spiral underway, few nutters out there are prepared to buy mortgage-backed securities (or MBS). So the banks (and other institutions) who own these MBS have been seeing more and more losses every day, and their balance sheets are at risk.

So Ben becomes increasingly worried with how illiquid the market is and throws out the following offer:

“Why don’t you give these illiquid mortgage-backed securities (or MBS) to me? I’ll exchange them with liquid stuff, like, U.S Treasuries. The downward spiral in the price of MBS’s must stop!”

How nice of him, thought the markets.. so stocks rallied!

But then the “economists” began to mutter.

“You know, Ben is not being that generous.” And this for a number of reasons:

First, banks don’t really need someone to hold the crying baby. They want someone to take it away from them… for good! But the Fed did not offer to buy the MBS. It will only hold them temporarily until market conditions improve, confidence is restored and prices begin to reflect the “real stuff”, that is the capacity of you and me to repay our mortgages—not liquidity shortages…

…Wishful thinking! The measure is predicated on the assumption that the crisis is a crisis of liquidity rather than one of solvency. But I (and not just I) beg to disagree. There is a solvency (or, rather, insolvency) problem in the housing sector and, unless it is resolved, it is difficult to see how confidence and liquidity can be restored.

Secondly, despite the psychological impact of the announcement, the Fed’s “intervention” in the MBS market is

(a) small, at “only” 200 billion dollars; and

(b) limited to the “high-end” triple-A-rated stuff.

“Small” because, even at $200 billion, it is still a drop in the bucket compared to the six-trillion-dollar worth of mortgage-backed securities. And when it comes to (b), the point there is that the non-AAA junk that is lingering in the financial system’s balance sheets, and whose value has dropped calamitously, will… remain there!

Third, the Fed did not reveal at what price it will accept the MBS in its books. That’s right, when the Fed lends cash or US Treasuries to the dealers, it asks for collateral, and it typically prices this collateral at a discount, depending on the quality of that collateral.

For example, if I am a dealer and I want to borrow $10 million worth of US Treasuries, I will have to give collateral so that if I go bust the Fed can recoup its money. If my collateral is, say, municipal bonds, I will have to deposit around $10.5 million worth of these with the Fed, because they are riskier than the US Treasuries and the Fed wants a cushion in case their price falls.

So the issue at stake is that, if the Fed is conservative and says “I’ll be happy to accept your MBS as collateral, but only at 70% discount”—a number I just made up—it might not go down well with the markets! In other words, the usefulness of the measure will depend on how the Fed's discount compares with the discount these securities are trading in the market.

So, repeat after me: “Big Deal!” Well, unless something bigger is in the offing: A big fat bailout of homeowners and their bankers, whereby banks are kindly asked to bail out homeowners, the Fed steps in to bail out banks, and the Federal government steps in to “save” the Fed.

So why did the markets rally? Did they really see today’s measures as a precursor of a bailout? Maybe.. otherwise, I’d be really (really!) tempted to speculate it was the “petite brunette” effect!

PS And a note to Silda Spitzer.. Could you please punch your husband on the nose, hard, rather than standing beside him like a sorrowful accessory of a wife? On tape please..

Glossary: mortgage-backed securities, liquidity vs. solvency, collateral, big fat bail-out, call-girls.

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