Wednesday, January 28, 2009

Messing around with credit

Each time Ben comes out to speak these days I open my drawer to reach for a glass of scotch. Not that I keep a bottle of scotch in my drawer… I’m just saying... that’s what I’d do if I had one.

So here is what gets me flustered.. Credit markets are broke, so the guy sets up all these liquidity facilities—the TAF, TSLF, PDCF or (my favorite acronym) the ABCPMMMF . Great! I mean, slow, piecemeal, reactive but still.. At least banks now have access to all the dollars they need to finance their day-to-day business, including (you would think) lending to the private sector.

But things remain broke, so then Ben comes up with the CPFF and the TALF. Even better… Now the Fed has the infrastructure to lend to the non-financial private sector, so long as financial markets refuse to do so, and thus keep the flow of new credit to creditworthy borrowers.

What I have trouble with is the Fed’s program to purchase Fannie and Freddie debt and mortgage-backed securities (MBS)... and Ben’s stated motivation behind it: “ provide support to the mortgage and housing markets.” (from today’s FOMC statement).

Here is my problem… problemS rather: First the MBS purchases are intended to support the mortgage and housing markets by trying to directly affect the yields of MBS (and, by extension, of mortgages). That surely can’t work in a sustainable way unless (1) you address the imbalances in the housing market; and (2) you fix the balance sheets of mortgage providers so that they can actually afford to make new loans.

You can fix (1) by letting the private sector work its way through the imbalances. Unfortunately, this means letting house prices fall further, so long as valuations warrant it. Now, if you, government, actually want to do something, you could help prevent prices from undershooting… e.g. with schemes to stem foreclosures and avoid additional supply coming on the market. But as long housing remains overvalued, supporting house prices through artificially low mortgage yields is not sustainable, nor even desirable.

When it comes to banks’ balance sheets, you know my story already… You can fix those by taking steps to directly alleviate the pressures both on the asset side (carving out the toxic stuff) and on the liability side (refilling the hole in their capital). But buying MBS won’t do the job unless it’s part of a bigger plan to deal with this problem—in which case the program should be designed accordingly.

So I said problemS. Here is my #2: With the MBS purchase program in its current form, Ben is messing around with credit allocation. I mean, why pick housing over other credit markets? Like, investment grade firms or even high-yield corporate bonds? If anything, American firms on aggregate are far less indebted than American households! And they could actually use the money to produce stuff.

No, no “corporate elitism” intended. I’m just baffled by the intention to support more household debt, when such over-indebtedness was what caused our problems in the first place! Especially when the support comes from the Fed, of all institutions, which has been insisting for years that it should not be in the business of credit allocation!

Finally my third problem: Unlike the Fed’s other facilities, most of which have been established under the premise of “exigent conditions,” and will be law or by design be allowed to expire once conditions normalize; the Fed can hold its agency MBS and Treasuries as long as it pleases.

Some have feared that this could bind Ben’s hands when it comes to absorbing all the excess money floating around, once conditions normalize… with the concomitant threat of inflation. But that’s not the problem: The Fed has the ability to control monetary conditions, no matter the size of its MBS holdings, by virtue of its recently-established authority to pay interest on bank reserves.

What one may question though is the Fed’s willingness to do so. Nothing personal, Ben, it’s just that the track record of the Fed in this respect has been arguably undermined by its actions in the not-so-distant past.

So I’ll go back to the very same call, again: Let’s see whatever MBS purchases occurring in the context of purchases of a broader set of (toxic/troubled) assets, aimed at bringing back the financial sector to a healthy footing. Let’s see all of that being managed by a Structure Investment Vehicle (SIV), financed by the Treasury/Fed but acting independently from them, including from the monetary policy process. And let’s set as an explicit mandate for this SIV to maximize profits for the taxpayer!

So, Scotch anyone?


killben said...

I need scotch when Ben or Bair start off ... SURE that they will make matters worse and SURE THAT the tax-payers will be POORER once the ideas gets going ..

How did they get there to wreak such havoc .. and when are they going to be set free to wherever they want to go without endangering the tax-payers

Anarchus said...

Nice work.

My personal favorite Bernanke debacle was the original TSLF being announced on Tuesday, March 11th. Considering that the capital markets had been worried for days that Bear Stearns was having financing issues, the Fed's announcement of the TSLF added to market fears - why else would the Fed do something so innovative and large if some important financial institution wasn't in distress? The next morning, I sent a friend an email calling the TSLF "the Bear Stearns bailout act of 2008".

What I was a bit slow to catch on to (I am a dull-witted equity guy, after all) was that the TSLF wasn't to be started up until TWO WEEKS later on March 27th! Kind of like announcing to the world that you have a guy bleeding to death in the street but not giving them a transfusion until two weeks later. So the Bear didn't even make it through the weekend of March 15-16 before going out of business. Nice job, Ben.

It's getting increasingly clear to me that the crisis can't end until home prices adjust downward to the old long-term average income-to-home price ratio . . . . . . because the fact is no one can cause home prices to remain above their rational, market-clearing level and our leaders shouldn't even bother to try because that'll just drag out the pain. And yes, the mortgage debt and derivatives and CDOs will continue to decline in price until the underlying home values stabilize and the losses will pile up - maybe not quite in Roubini's $3 trillion+ magnitude, but maybe they will - the guy's been right more than anybody else and home prices still have to fall another 20% minimum.

Moopheus said...

Thanks for this. Whenever I hear someone say "it's a great time to buy a house" because "rates are low" I start frothing irrationally. I do believe that the Fed and the other agencies are still trying to play kick the can down the road. When the Fed says "support the housing market" they must surely mean "keep prices from falling further." Since they are paying for the MBS by "creating new reserves," I can only conclude that they are hoping to support nominal prices by eroding real value with inflation, and hoping that incomes keep up. But if wages don't rise, then house prices must surely continue to decline. Which just passes on the problem to the next round of buyers. I, for one, would like to buy a house, but this is a game I do not want to play. Will lower rates now help me save for a downpayment, or decrease the LTV ratio of my loan? No, the will not? Will I be helped later if I should need to sell and rates have gone up? No, I will not. If I buy now, then I must either pay out an uncomfortably large portion of my savings as a downpayment, or take an overleveraged loan, leaving me in a riskier position. I am still better off waiting to see if prices fall further. Am I wrong?

The program acronyms I am waiting for are BARF and SPLIFF, since that is what I feel like doing, and what they must be smoking.

Merry-will-go-round said...

Moopheus, I agree. In addition to all the reasons you cited for not being willing to move into the mortgage buying game now, I'd add property taxes and inflated maintenance costs to the mix. And if you're counting on Social Security should you become disabled or old...buying soon could be particularly dangerous. Wait it out. News of the bitter aftereffects of these addictive bailouts and stimulus bills cannot be suppressed much longer. We will be barfing for a long time.

Anonymous said...

The Fed is insolvent if you look at their balance sheet.