Seeker Blog

The root cause of the credit collapse is that lenders do not know what the “concrete” on the borrowers’ balance sheets is worth. That fact is driving Friday’s Treasury proposal.

I don’t see how the Treasury plan answers the valuation question — paying above-market prices for unknown paper doesn’t tell me what your mortgage is worth. I.e., we do not achieve Recognition.

The Treasury plan doesn’t address Relief at all. What we seem to get is a partial Recapitalization, but one where those
who made the mistakes get the profits while the taxpayers get all the losses.

For reference, the thumbnail at left, thanks to Yves Smith, links to the graph of the history of Total Credit Market Debt as a % of GDP through 3/31/2008, part of Yves’ 28 July Has the Deleveraging Even Begun?.

Today Yves assembled some sharp commentary on the proposed Treasury authority. I strongly recommend that you read the whole thing, but beginning with this overview

Reader Marshall forwarded a note from Jon Hatzius, the Goldman analyst who was an early housing/financial firm bear and has forecast that credit-related losses to the economy will reach $2 trillion. His outline of what the rescue program must do:

Basically, I see three main conditions for resolving the crisis (a slicker marketer would call them “The Three R’s”):

a) Recognition. We need to find out what the assets on the balance sheets of banks and other financial institutions are really worth, and what the balance sheets of the most troubled institutions look like under a regime of realistic marks.

b) Recapitalization. The US banking system needs a lot more capital. Credit losses are depleting equity capital, and deleveraging increases the required equity capital per unit of balance sheet capacity. So capital infusions are needed to avert a sharp contraction in lending.

c) Relief. In many cases, we need to restructure the loan terms of homeowners who lack the ability (or economic incentive) to service their mortgage. This isn’t just in the interest of the homebuyers, but it’s often also in the interest of the lender (given the cost of foreclosure) and certainly in the interest of the macroeconomy (given the feedback effects between foreclosures, home prices, and economic performance)….

In any case, recognition is only a start. In fact, recognition actually increases the need for recapitalization because it brings capital shortfalls out into the open. So it will be important to see how the Treasury proposal addresses this. Do they force banks to seek equity infusions from private investors in a specified time period? Do they simply “pay over the odds” for the assets (this would promote recapitalization but jeopardize recognition)? Is part of the program earmarked for the purchase of preferred stock in banks? Or is there a public/private partnership scheme such as an issuance of publicly financed puts in e xchange for warrants for would-be private investors?

As we read from the Congressional staffer, they simply want to “pay over the odds”.

A guardedly hopeful view from an economist I respect, former Fed vice chairman Alan Blinder:

“It goes a long way; it ameliorates it very substantially,” said Alan S. Blinder, an economist at Princeton and a former vice chairman of the board of governors at the Federal Reserve, who has said for months that the government must step in forcefully to buy mortgage-linked investments.

“We’re deep into Alice in Wonderland’s rabbit hole,” Mr. Blinder said.

…Many economists say such questions are beside the point. The nation is gripped by the worst financial crisis since the Great Depression. Before Thursday night, when the Treasury secretary, the Federal Reserve chairman and leaders on Capitol Hill proclaimed their intentions to take over bad debts, the prognosis for the American financial system was sliding from grim toward potentially apocalyptic.

“It looked like we might be falling into the abyss,” Mr. Blinder said.

…“It’s easy to forget amid all the fancy stuff — credit derivatives, swaps — that the root cause of all this is declining house prices,” Mr. Blinder said. “If you can reverse that, then people start coming out of their foxholes and start putting their money in places they have been too afraid to put it.”

…“It’s not enough,” Mr. Roubini said. “But it’s the first time they have done something that makes a difference.”

Other Fed and Treasury stabilization actions are underway as part of a “Broad, Systematic Approach” according to the WSJ:

…While the Treasury department awaits approval from Congress it is also moving to start buying up mortgage-backed securities through existing mechanisms. The Federal Housing Finance Agency, a division of government that is effectively running both Fannie Mae and Freddie Mac, immediately directed both companies to purchase more mortgage-backed securities to help fund lending markets.

The Treasury department also plans to expand a program it implemented in the wake of its takeover of Fannie and Freddie to buy up to $10 billion in mortgage-backed securities debt issued by the companies in the open market. The Federal Reserve and the SEC also acted to stem the crisis.

The Fed acted before U.S. markets opened, effectively coming to the rescue of the money-market mutual-fund industry. Worried that money-market mutual funds weren’t liquid enough to handle a wave of redemptions from nervous investors, the Fed said it would use its so-called discount window to lend up to $230 billion to the industry — via commercial banks — against illiquid asset-backed commercial paper which is widely held by money-market funds.

The asset-backed commercial paper market went through severe strain last year, because of holdings of troubled subprime mortgage debt instruments. Fed staff say that isn’t a problem for the industry now, and that most of the assets backing the instruments it will lend against are auto loans and credit-card loans. The paper the Fed is financing is high-rated and Fed staff don’t see it as a money-losing step.

The central bank is taking on a potentially big risk: If these assets fall in value or default, it may be on the hook, because the Fed cannot claim anything other than collateral as repayment. Officials say the assets are safe and the move is a temporary measure to provide liquidity to the market.

In another bid to provide liquidity, The Fed Friday, said it would buy short-term debt issued by Fannie Mae, Freddie Mac and Federal Home Loan Banks through primary dealers. The Fed said it would buy up to $69 billion of these securities, called discount notes, to ease the crunch in the market.

The SEC ban on short selling of some financial stocks — an attempt to stem some of the worst stock-market slides in years — is effective immediately and will last 10 days, but could be extended for up to 30 days.