August 12, 2007
The "sub-prime crisis" is, in fact, a REAL crisis. This is one of the very few times in this observer's LONG MEMORY that the media has understated a potentially critical risk. Exaggeration, as we all know, is the media's stock-in-trade. (Hence, the stock market does not decline; it "PLUNGES" or "TUMBLES".) At its core, the collapse of the mortgage-backed market erodes the capital of the banking system, as well as its ability and willingness to lend. Credit is the essential lubricant of our economic system; without it the economy would grind to a halt. The enormous quantity of low quality debt, its wide -- if currently unknown dispersion, and the prospective domino effect of intensifying capital erosion and debtor inability to service their debt constitutes a grave threat to the banking system and to the economy. Continuing and drastic measures will be required of the Federal Reserve and the European Central Bank (ECB) to contain the crisis and prevent it from bringing down the entire financial structure of the United States and Europe. The early fall-out from the crisis is intensifying deflationary pressures in real estate, with effects soon to be felt in the ...consumer economy. The Fed may, at the very least, have to purchase and hold a huge quantity of mortgage-backed bonds, purchasing them for par value, rather than market value, in order to maintain the viability of the banking system. Down the road, we are looking at a taxpayer-funded bailout which may make the S&L cleanup of the early '80s look like child's play.
In earlier times, a situation of this type would have created a true financial panic , rather than a panic limited, at least thus far, to certain sectors of the credit market with a spillover in the form of a mild stock market correction. Such a crisis would in the past have been transmitted from the financial markets to the banking system, and then, through the banking system into the general economy. The end result would have been an economic depression -- one of a series which have punctuated American economic history every twenty or thirty years (The agricultural depressions of the 1830s and the 1850s, and the serious industrial depressions of the 1870s, the 1890s, and of course, the Great Depression of the 1930s come to mind).
Like previous panics, the seeds of the current mortgage debt and the forthcoming junk bond crisis are all-too-familiar. Low interest rates and abundant liquidity fuel rising asset prices (in this case, house prices and mortgage-related and other low quality debt). This rise in asset prices stimulates overspeculation, which is fanned by rapidly expanding borrowing and over-leveraging. All of this occurs in an ever-widening attempt to exploit to the nth degree the apparently endless rise in the underlying asset value. Human nature being what it is, greed is tamed only by fear (or, in our society, by imprisonment). As the intoxicated herd surges excitedly forward, the gap between price and value widens. As is always the case in speculative manias, an imaginative cornucopia of rationales and "explanations" are offered to rationalize the burgeoning overvaluation. Dismissing all of this nonsense are the smartest tier of speculators, the first in, those with the largest profits. These speculators sell first, before the fear sets in, just as they bought first, before the greed developed. This selling, at over-inflated prices, puts pressure on the most over-leveraged asset owners, some of whom are forced to sell as the initial sales by the smart money push prices lower. Asset prices start to decline. Asset owners, who have by now reached the most stretched limits of their borrowing power, are unable to support the declining market. As prices fall, more sellers materialize. The downward spiral is now underway, with the bottom not even remotely in view. Indeed, until massive and very painful liquidation occurs, the bottom will not be reached.
The downward spiral in the current crisis has by now become apparent to all, even to the Federal Reserve, whose earlier inaction allowed the mania to develop in the first place. In the vanguard of the first wave of involuntary selling are the most precariously positioned speculators -- the hedge funds receiving margin calls, the mortgage companies, and, most importantly, the banks. But now there is no one to sell to. Where have all the buyers gone? It's like the old joke about stock speculation; the broker keeps calling the client, telling him how great stock X is and how much it is going to rise. Each time the broker calls, the "investor" buys more, at ever-higher prices. Finally, thrilled at his "profits," the investor calls the broker and tells him to sell. The broker responds: "TO WHO?"
Panic is not merely a state of mind, although it is in part that. There are occasions on which a financial panic IS A RATIONAL RESPONSE TO OBJECTIVE CONSIDERATIONS. If an individual, or an organization, has bet its future on an asset that is no longer salable, or that can only be sold at a price so diminished that it causes the investor grievous, if not irreparable loss, panic is an understandable and reasonable reaction. The key question in the continuation of the current panic is whether the central banks will act as buyer of last resort. If so, the Fed and the ECB had better be prepared to print up a couple of trillion dollars/euros. The taxpayer will be ponying up to pay for a bailout which could dwarf the savings and loan cleanup.
Speculators -- and the financiers and facilitators of speculation -- the blue chip banks -- periodically forget the law of financial gravity. In the heady excitement of the moment, with waves of money rolling in, they choose to believe what it is convenient for them to believe. In due course, the lesson of financial history is brought home once again. Every mania comes to an end. Or, as the head of the fictional banking family, the Pallisers, put it so aptly: "There will always be crashes."
It is not our purpose here to assess the role of the banking system in financing this current variant of the recurrent financial mania. Let us simply note that the current generation of blue chip bankers are the peers of their predecessors, the dark suited bankers of the 1920s who accepted bone china as collateral for loans made to finance stock speculation.
In the current case, Wall Street financial "engineers" created vehicles whose purpose was to increase geometrically the quantity and marketability of low quality mortgage debt until it seeped into every nook and cranny of the financial system. This process was PASSIVELY ASSISTED by the Federal Reserve and the other regulatory authorities. They did not fulfill their responsibilities and act as guardians of the public weal. They did not utter a peep as this mountain of debt grew like topsy.
Indeed, the Fed has remained wedded to its unidimensional view of its job. Its sole responsibility is to keelhaul the pitiful remnants of "inflation." Only when this "policy" -- in conjunction with ignoring its other responsibilities -- produces disaster does its world view expand. In their endless public incantations against the evils of creeping inflation, and in donning their suits of armor to do battle with the infidel, the Fed ignores its legally defined mandate. The Federal Reserve Act of 1913 established the Fed. The Act was passed in response to the Panic of 1907. While JP Morgan did act decisively as the provider of liquidity of last resort in the crisis, the Congress determined that it would be imprudent to depend upon one man, who might not act in time, or who might not possess adequate resources. The Congress therefore created a central bank, with the PRIMARY INTENTION that it act as the lender of last resort. In a broader sense, the Fed's responsibility was to prevent the emergence of conditions which would foster manias and the ultimate panic and subsequent depression.
To say that the current Fed has failed to meet its primary obligations is to state the obvious. The Fed's inflation monomania led it to ignore more dangerous problems -- such as the unlimited proliferation of potentially fatal "financial instruments" and irrational mortgage lending. Beyond this, the maintenance of an ultra-tight monetary policy in the context of the uncontrolled growth and securitization of dangerous lending ensured the eventual emergence of a systemic threat.
Washington, by closing its eyes to these dangerous practices implicitly placed its imprimatur on them. And of course, Wall Street and the banks, not to mention the less savory players, ran with the ball. This should hardly have come as a surpise. It would appear that none of the bankers, economists, and businessmen who constitute the policymaking echelon of the Fed had even a minimal amount of foresight, wisdom, or prudence. The altenative explanation for their lassitude is that they lacked the guts to take an unpopular stand. The magnitude of the crisis -- whose full dimensions we do not yet know --is consequently their responsibility. It's high time for the Fed to confess its sins of omission and commission. However, the central bank chooses, as always, to blame others for its failings. Hara kiri is not a popular activity in Washington.
No Depression
There will be no depression this time around. For this there are two reasons: the New Deal Reforms, and the probable behavior of the Federal Reserve in coming weeks and months. The most important innovation of the Roosevelt Administration was the introduction of bank deposit insurance. Backed presumably by "the full faith and credit of the United States," deposit insurance has kept the anxiety level of depositors well below the the threshold of panic during even the most stressful periods. Thus, liquidity will never vanish entirely, as it did in the early 1930s. The public believes that there is more than a government promise here . The government will employ its full power to make good on the FDIC guarantee. The government's power to tax, and, in the greatest of extremities, its power to print unlimited quantities of money, will enable it to make good on its commitment. Our politicians are determined never to allow another bank panic to occur. Moreover, this is one of the few things they are good at -- taxing and printing money. The bottom line: whatever financial breakdowns may occur, the ultimate catastrophe and guarantor of depression -- depositor panic and massive withdrawals -- will not occur.
Probable Behavior of the Federal Reserve as the Crisis Unfolds
The second factor precluding a depression is the likely behavior of the Federal Reserve -- which on August 9th and August 10th acted decisively in supplying unlimited reserves to the banking system. Indeed, the spike in the overnight interbank lending rate to 6% -- 75 basis points ABOVE the Fed target -- was an extreme danger signal to which the Fed responded promptly. It is crucial to note that there was apparently an acute shortage of bank reserves on the 9th. The fact that major banks were frantic to borrow reserves at virtually any price is not a function of panic. Banks do not panic. The frenzied overnight borrowings at virtually any cost suggest the severity of the liquidity impairment of the banking system. This is not exactly comforting, as we can only presume that the liquidity crisis is nowhere near its crescendo. Only part of the iceberg is currently visible; only a few fund failures have thus far been publicly acknowledged.
To the immense surprise of everyone -- including the central bankers -- serious liquidity problems have suddenly surfaced in European banks. The German govenment has already placed one major bank on life support, and is rendering aid to others. Banque du Paribas, the largest bank in France, has frozen withdrawals from some of its investment funds. These funds cannot "price" their assets. In other words, the assets have no current market value. AND THE UNDERLYING MORTGAGE SERVICING CRISIS CAN ONLY GROW WORSE. There are reportedly upwards of $600 billion in American mortagages to be reset -- AT MUCH HIGHER RATES -- over the next 18 months. UNLESS THE FED REDUCES INTEREST RATES QUICKLY AND DRASTICALLY, there will inevitably be an intensification of the upward spiral in "non-performing" mortgage loans. The downward pressure on mortgage bond prices can only intensify. Consequently, the level of impaired assets, and the lending capacity of the banking system here and in Europe will shrink -- possibly dangerously.
In fact, a systemic risk now confronts the banking system. And despite the oceans of ink spilled to advance the thesis that banks no longer matter since other financial institutions now provide similar services, the fact remains that a healthy banking system is essential to a functioning modern economy. Simply put, without the rolling over of loans and the provision of additional credit as needed, the economy will collapse into a general depression. The "alternative" financial institutions are now in the throes of their own severe crisis, a consequence of their greed, herd behavior, and the absence of any meaningful regulation.
We cannot presently assess the degree of jeopardy into which the financial system has been placed by bank financing of unwise mortgage loans, leveraged buyouts, and the provision of excessive credit to hedge funds. Many of these loans are "secured" by unreliable collateral. What we do know is that the forthcoming contraction of lending will not be resolved solely on the basis of a restoration of "confidence." Even the restoration of "confidence" will require more than the provision of unlimited liquidity by the central bank. The return of "confidence" cannot in and of itself bring the value of mortgage-backed securities up to anything like prior levels AS LONG AS THE INCOME FLOWS which form the basis for the value of these securities are not restored. With the impending tidal wave of mortgage resets at much higher rates, the downward pressure on house prices will intensify, and the ability to refinance and service mortgage debt will continue to weaken. Consequently, the Fed must address the question: how can confidence be restored in the viability of assets which not only have no buyers (mortgaged-backed securities), but which are unlikely to produce any non-cental bank buyers in the future, since THE FUNDAMENTTALS UNDERLYING THESE SECURITIES CONTINUE TO DETERIORATE. At bottom, the problem is that more and more borrowers are UNABLE to service their mortgages. Consequently, the bonds and obligations backed by these mortgages CANNOT produce the income stream for which they were purchased, and which give them their value. The generality of holders of these trillions of dollars of securitized debts and related "derivative" instruments -- whether they be banks, university endowments, pension plans, investment funds, hedge funds, or private investors can only suffer deepening financial loss. There is a sharp limit to the amount of capital speculators can reasonably be expected to deploy in purchasing these securities at any but the most depressed prices. Restoring a market for these securities, and making it possible for the banks to "value" their holdings by marking them to market will only reveal the deep hole in the banks' net capital.
The only way in which this danger can be obviated would be if the central banks themselves purchase all mortgage-backed securities which are offered for sale. This would transfer the staggering losses from speculators, risk-taking financial institutions, and yield-hungry individuals to the taxpayer. Only by ridding themselve of their non-performing mortgage-backeds can the banks regain their ability to lend at an acceptable level. Moreover, a great deal will depend on how much the central banks pay for the privilege of acquiring this junk. Will they pay 100 cents on the dollar? This may well be necessary.
Indeed, according to at least one unconfirmed news account, the Federal Reserve actually did purchase, or at least loan money to banks collateralized by some $30 billion plus of mortgage backed securities on August 9th and 10th. If this is so, it attests both to the seriousness of the situation of the banks, and to the commendable speed with which the Fed is now acting.
The Fed will need to go well beyond supplying unlimited liquidity to the banking system and purchasing mortgage securities at par value. While the Fed can shovel money into the banking system, it cannot force banks to lend, nor can it force borrowers to borrow. The Bank of Japan learned this sad lesson after 1989, when its tight monetary policy finally caused a collapse in the superheated real estate and stock markets. Japan langusihed in a no-growth limbo for fifteen long years.
The restoration of bank lending to normal levels will require that such lending be made profitable for the banks. Indeed, because of the losses and capital impairment the banks have already experienced, their lending must be made substantially more profitable than normal. The issue here is the structure of the yield curve. To put the matter plainly, the Fed, in driving short term rates above long-term rates, has severely eroded the profitability of bank lending. Banks, after all, borrow short and lend long. The Fed must not only normalize the yield curve, but it must drive short rates far below long rates. This will require a major reduction in the Fed-controlled overnight rate.
In fact, it is the Fed's own monetary policy errors which are primarily responsible for the real estate bubble and for its subsequent collapse, with consequences we do not yet fully comprehend. The Fed, in its panic over the perceived threat of DEFLATION in 2001 and 2002 flooded the system with excessive liquidity, as it drove the funds rate down to an unprecedented 1%. It was this money flood which provided the fuel for the real estate mania, and the mortgage madness which followed in its wake. In 2001-2002, the Fed chose to ignore the obvious risk of swamping the financial system with liquidity. Since the consequences of this sort of super-easy policy are well-know from previous manias, the Fed can hardly claim ignorance as an excuse. They knew what they were doing. The simple truth is that they miscalculated badly.
The Fed then swung to the opposite extreme, overcorrecting the super-easy policy with a super-tight policy. This ultimately punctured the bubble they themselves created. Now we all reap the whirlwind.
Investment Implications: In Treasuries We Trust
Tbe sub-prime crisis will likely benefit Treasury securities, especially long-dated Treasuries. Bond prices move inversely to interest rates; the more distant the maturity date the greater the percentage change in price as interest rates decline. Long-dated Treasuries are already benefiting from the shock produced by the collapse of the mortgaged-backed market; the early stage of a financial crisis is always marked by a flight to safety. Treasuries are the safest investments on earth and are thus the primary initial port in the financial storm. The more severe and worrisome the subprime crisis becomes, the greater the positive impact of the flight to safety on the Treasury market.
The flight to safety is only the initial component of the cyclical bull market in Treasuries which now appears to be taking hold. The inversion of the yield curve -- which has been largely in place for at least a year, alternating periodically with a flat curve -- has historically proven to be an extremely reliable leading indicator for the economy, inflation, and interest rates. The significance of an inversion is very clear, despite the unrelenting efforts of the Fed to muddy the waters with endless assertions that " this time it's different." (As those with any measure of investment experience know, this incantation is a clear signal to head for the hills, pronto. ) An inversion has historically been an ironclad forecast of a very serious impending economic slowdown, culminating if not in recession then, at the minimum, in quasi-recessionary conditions for a protracted period. Additionally, when investors are happy to lend long to the government for a LOWER RETURN THAN LENDING FOR SHORT TERM, it is irrefutable evidence that perennially nervous bond investors are certain that the rate of inflation will diminish notably in coming quarters. Bond investors, unlike the Fed, put their money where their mouth is. Ultimately, the inversion/flattening profile is followed by a significant decline of interest rates across the maturity spectrum, and an attendant rise in bond prices.
The subprime crisis, in conjunction with -- and to a substantial degree in consequence of the Fed's raising short rates too high and keeping them elevated long beyond the point at which prudence demanded the adoption of a rate-cutting policy -- will inevitably worsen the economic slowdown which, in fact, has been underway for the better part of the year. Since it takes 12-18 months for rate cuts to work their way fully through the economy, we can count upon at least 18 months of notable economic weakness and deflationary pressure, with consequent benefits for Treasuries. The onset of the subprime crisis will have a chilling effect on lending regardless of what the Fed does in coming months, and the economic softening will be that much worse the longer the Fed delays reducing sharply the overnight rate. At this juncture, the risk/reward ratio for long-dated Treasuries and for long-dated zero coupon Treasuries appears to be as good as it ever gets.
NOTE: FUTURE COMMENTARIES WILL ASSESS THE IMPACT OF UNFOLDING AND PROSPECTIVE ECONOMIC, FINANCIAL, AND POLITICAL DEVELOPMENTS AND TRENDS ON EQUITIES, CLASSES OF EQUITIES, AND OTHER ASSET CLASSES
