Regarding The Length of The Period of Turmoil in US Fixed Income Markets

I recently had lunch with a friend to discuss investing and the current economic conditions.

In her opinion, the equity markets are poised for more declines.

I don't disagree with her. Right now, my partner and I are positioned in puts, and our equity allocation signal is to the short side.

Regarding the economy and credit markets, I believe that the longer and deeper various regulatory and legislative authorities muck around in the current turmoil, the longer it will take to arrive at market clearing prices and, thus, recovery in various markets and the economy.

Two areas in particular come to mind: structured financial instruments and home values.

In discussing these with my friend at lunch, I reiterated that structured financial instruments such as CDOs may have no current, tradable market value, while still being performing assets.

Thanks to the genius of the latest batch of young Wall Street wunderkinds, we have a conundrum in which an instrument which possesses intrinsic value by virtue of the normal operation of the underlying assets and payment streams is forced to be valued, for accounting purposes, as having virtually no value.

If we decided to focus the question of valuation on performance, rather than market value, then some of the recent value destruction at various investment and commercial banks would have been unnecessary.

Paradoxically, I think that structured financial instruments are causing much unnecessary damage due to some wrong-headed valuation decisions, when their long-run values are actually fairly robust. At this rate, some hedge funds and private equity shops will surely reap most of the longer-term value from these instruments, if only to buy them at fire-sale prices and simply collect the interest. Not having to meet public valuation standards, these firms logically will bottom sweep the market and realize most of the profits.

Does it not seem somehow mistaken that our regulatory and accounting structure make it impossible for publicly-held banks to do the same?

Then we turn to housing values.

Here, Congressional ass-covering and regulatory power-grabbing are conspiring to prevent the useful and natural fall in housing prices until they reach market-clearing levels.

So long as bribe-taking Senators like Dodd and Conrad push for Federal forbearance of mortgage defaults and the implicit support of home prices, nobody in their right mind will be buying distress housing.

When you know someone is artificially propping up prices, why bother paying good money for over-priced real estate?

The longer this continues, in its many forms, including FDIC freezing of foreclosures at IndyMac Bank, expanding Freddie's and Fannie's lending authority, and the attempts by Congress to forgive defaulting homeowners, the longer credit will avoid returning to finance housing.

And the longer buyers will wait to purchase excess/distress housing stock.

Of course, the Resolution Trust Corporation solution of the 1980s worked in the opposite direction, and very effectively at that.

Naturally, then, the current Congress is heading in the other direction.

If Congress has its way, who knows how long housing values could take to reach market-clearing levels, thus opening the way for new financing to enter the sector?

Thus, I'm rather jaundiced about any particular economist's call for the date or quarter at which these markets will be healed.

Valuation rules for structured finance could keep the publicly-held banks undercapitalized for quite some time, while political meddling in housing finance could delay the return of those markets to normalcy for years.