Wednesday, August 22, 2007

Brian Wesbury's Excellent Analysis of The Current Credit Market Situation in the WSJ

We're very fortunate to have a lucid, informed and competent economist of the stature of Brian Wesbury writing frequently in the Wall Street Journal.

On Monday, Mr. Wesbury wrote an inspired piece entitled "The Fed's Job."

In brief, he makes the point that, throughout our country's history, people have wrongly diagnosed economic problems as 'a lack of liquidity.' Now, Wesbury explains, the problem is leverage and uncertainty- but not liquidity.

This is at variance with such biased commentators as financial entertainer Jim Cramer, self-interested Senator Chris Dodd (Democratic Presidential candidate and Senator from the home state of many hedge funds, Connecticut), and CNBC economist wannabe, Steve Liesman. All three of these observers have been shouting loudly for various 'liquidity' bromides, ranging from the Fed cutting the interest rate by one-quarter to one-half of a point, to allowing Fannie Mae and Freddie Mac to 'invest' in jumbo mortgages.

Thankfully, Wesbury explains why all of this is unnecessary, but, never the less, in the long tradition of populist blowhards crying for easy credit.

To wit, Wesbury wrote,

"Blaming monetary policy for economic and financial market turmoil is a time honored tradition. Maybe the most famous bashing was in 1896 when William Jennings Bryan, an original populist, ranted against hard money and for inflation: ". . . we shall answer their demands for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold."

Monetary policy makes an easy scapegoat because printing money (like drinking a cup of coffee) is an easy way to give an economy a temporary boost. But if what ails the economy or markets was not caused by tight money in the first place, a temporary boost will not help. It may cover up the symptoms temporarily, but in the end it does not solve the underlying issue (a lack of sleep).

In fact, easy money always leads to greater problems down the road -- either rising inflation, or a reduced sensitivity to risk, as markets come to expect rate cuts to bail them out.
Lately, modern-day William Jennings Bryans have been loudly calling on the Fed to cut interest rates and inject cash into the banking system. They believe more money would stop financial markets from seizing up any further.

This would make sense if money was already tight -- or to put it another way, if a lack of liquidity was the real issue. But trades are clearing, banks are well capitalized, commercial and industrial loans are growing, credit-worthy borrowers are getting mortgages, and the economy is still expanding.

...the current turmoil in the financial markets has nothing to do with a lack of liquidity. More importantly, there is little hope that any liquidity the Fed would inject into the banking system would actually get to the sectors of the market where only sporadic, fire-sale pricing of securities is taking place.

Some are arguing that a sharp decline in the three-month Treasury bill yield, to 3.85% from roughly 5% during the past few days, shows the need for a huge infusion of cash that would force the federal funds rate down. But the drop in T-bill yields is a reflection of three issues: a flight to quality, a guess that the Fed will lower rates at its next meeting and a very liquid market."

Well, if liquidity, per se, is not needed, then what precisely is going on currently in financial markets? Wesbury continues his article with this explanation,

"The real problem with the financial markets is that extreme leverage and extreme uncertainty have met in the subprime loan market. No one knows how many loans will go bad, who owns these mortgages and what leverage they have applied. We do know that subprime lending is just 9% of the $10.4 trillion dollar mortgage market, and delinquencies are running at about 18%. The Alt-A market is about 8% of all mortgages and about 5% of this debt is delinquent.

As an example, let's take a very low probability event and assume that losses triple from here. Let's assume that 54% of all subprime loans and 15% of all Alt-A loans actually move to foreclosure. Then, assume that lenders are able to recover 50% of the value of their loans. In this scenario, total losses in the subprime market would be 27%, while total losses in Alt-A would be 7.5%.

From this we can estimate a price for the securitized pools of these assets. Without doing any actual adjustment for yields, or for different tranches of this debt, the raw value of the underlying assets would be 73 cents on the dollar for subprime pools and 92.5 cents for the Alt-A pools. Getting a bid on this stuff should be easy, right? After all, the market prices risky assets every day.

But this is the rub. A hedge fund, or financial institution, that uses leverage of 4:1 or more, would be wiped out if it sold subprime bonds at those levels. A 27% loss on Main Street turns into a 100% loss on Wall Street very easily. But because hedge funds can slow down redemptions, at least for awhile, and because they are trying desperately not to implode, they hold back from the market. At the same time, those with cash smell blood in the water, patiently wait, and put low-ball bids on risky bonds. The result: No market clearing price in the leveraged, asset-backed marketplace."

Thus, Mr. Wesbury comes to the logical and sensible conclusion that what we are witnessing is not a shortage of liquidity, but the realization on the part of a lot of supposedly-smart hedge fund managers and other institutional investors, that they weren't so smart in their headlong use of sub-prime mortgage-based instruments without understanding the underlying risks to those mortgages. It's no different than any other case of sophisticated and/or institutional investors making poor investment choices- they lose money. In the cases of many of the hedge funds, some of whom call Senator Dodd's state home, they have used leveraged money, and are, quite likely, now insolvent.

So we have populists crying for the relief of wealthy hedge fund investors and managers, at the same time that they also cry for relief for the sub-prime mortgage borrowers! At least it's equal-opportunity financial forgiveness. However, it's unnecessary.

In his conclusion, Mr. Wesbury goes on to state,

"There is a lesson here. Populism is in the air these days, and the threat from tax hikes, trade protectionism and more government involvement in the economy, is rising. This reduces the desire to take risk. Congress is working on a legislative response to current mortgage market woes as well. And as with the savings and loan industry (forcing S&Ls to sell junk bonds at fire-sale prices), and Sarbanes-Oxley, the legislative response almost always compounds the problems.

The interaction of an uncertain regulatory and tax environment with a highly leveraged, illiquid market for risky mortgage debt creates conditions that look just like an economy-wide liquidity crisis. But it's not. A few rate cuts will not help.

What William Jennings Bryan was really complaining about in 1896 was falling commodity prices, especially falling farm prices. What he and the other populists ignored was that these prices were falling because of productivity, not tight money. His "Cross of Gold" speech was a clear stepping stone to the creation of the Fed in 1913. Since then, inflation has been much higher than it would have been under the gold standard. But all that inflation never did save the family farm.
Similarly, even very easy money today can't put off the day of reckoning for subprime mortgage holders who bought homes with no money down and thought interest rates would stay low forever. It can't help overly leveraged investors who thought they were getting risk-free 20% annual returns. Providing enough liquidity to allow markets to function, while keeping consumer prices as stable as possible, is the best the Fed can do. It should be all we really ask."

Amen, Mr. Wesbury. Ben Bernanke is wisely providing 'liquidity' to banks, in order that they may accept and offer, for repos, paper of dubious quality, in order to assure that credit markets continue to function, and do not impeded the normal course of our non-financial economic sectors. Truly, that's all for which we should ask from the Fed. Beyond that, borrowers and investors must accept the consequences of their own financial decisions.


Keith Gregory said...

The current lack of liquidity is from investors for good, alt a loans being originated today. Agreed that a rate cut won't affect that, but allowing Fannie and Freddie to selectively buy assets above their current portfolio limits might help.

There is no reason why Thornburg Mortgage with 58 bad loans out of 38,000 should be having problems. If you did anything that well, type, flip burgers, pick stocks, you would be viewed as near perfect.

I wrote more about this issue here:

C Neul said...


I disagree regarding Fannie and Freddie.

I have a friend who has done quite a bit of consulting for Fannie, and it's frankly still a mess.

Letting these two publicly-guaranteed, dysfunctional organizations into jumbos will be a nightmare.

Private business will be crowded out. And, as you note, Thornburg has done an excellent job in the arena. It's own CEO has implored Congress not to allow Fannie and Freddie to come in and essentially destroy his market.

Re Thornburg's, and other mortgage banks' current valuation issues, that's just the way markets work in a sudden panic.

It's not an indication of their long-term skill, but, rather, their lack of foresight in being bullet-proofed against the ability to market exotic debt instruments amidst a situation in which their own access to short-term credit evaporates.