Saturday, September 6, 2008

Can the Treasury Prevent Another Great Depression?

Surprise! The U.S. Treasury will bail out Fannie Mae and Freddie Mac. This confirms what we have known all along, namely, that there are two sets of rules, one for Main Street and one for Wall Street. When the former gets in trouble, the government ignores their plight but when the latter screams "Pick Me! Pick Me!" the U.S. government scrambles to bail them out.

Welcome to the new global order dominated by moral hazard. No wonder private equity funds want to get into the "too big to fail game" of U.S. financial institutions. Think about it: they get to rake their limited partners with outrageous fees and if they go belly-up, no problem, Uncle Sam (ie. taxpayers) will bail them out.

Anyways, late yesterday, The Wall Street Journal reported that the Treasury Department is putting the finishing touches to a plan designed to shore up Fannie Mae and Freddie Mac.

According to the WSJ:

The plan is expected to involve putting the two companies into the conservatorship of their regulator, the Federal Housing Finance Agency, said several people familiar with the matter. That would mean the government would take the reins of the companies, at least temporarily.

It is also expected to involve the government injecting capital into Fannie and Freddie. That could happen gradually on a quarter-by-quarter basis, rather than in a single move, one person familiar with the matter said.

In addition, Treasury's plan includes a top-level management shakeup at both companies, according to people familiar with the plans. Daniel H. Mudd, chief executive of Fannie Mae, and Richard Syron, his counterpart at Freddie Mac, are expected to step down from their posts eventually.

An announcement could come as early as this weekend. Some details are still being worked out, and terms of the arrangement could change.

Any move by Treasury would represent perhaps the most significant intervention by the government in the financial industry since the housing bust touched off turmoil in the credit markets a little more than a year ago. From the $168 billion economic-stimulus package in February through the bailout of investment bank Bear Stearns Cos., the Bush administration and the Federal Reserve have taken an increasingly aggressive stance in responding to what has become one of the worst financial crises in decades.

Fannie and Freddie are vital cogs in the U.S. housing market. Their troubles have threatened to worsen the bursting of the housing bubble, which has led to a surge in foreclosures. (See related article.) A Treasury intervention could help Main Street borrowers by keeping interest rates on mortgages lower than they would be in the event of continued instability.

It remains to be seen if this intervention will help out Main Street, but we know it will help bond traders like PIMCO's Bill Gross who has nearly $830 billion in assets and is one of the largest private holders of both U.S. Treasury and Fannie/Freddie debt.

Yesterday we also got news that the U.S. unemployment rate climbed to 6.1%. Over 600,000 jobs have been lost since the start of the year and it will get worse in the U.S. and around the world as this global crisis continues.

In his weekly market letter, Additional Thoughts on the Continuing Crisis, John Mauldin does an excellent job describing the current state of affairs.

I quote the following:

If there are in fact more large losses coming in the next year, what will the banks do? Raising capital is going to be tough and come at serious costs to current shareholders. We will see some of that, and that is a reason I would be very cautious about the stocks of large financial companies. The bulls would say that the problems are already in the price. Of course, that is that they said six months ago as well. Caution is to be taken.

The second thing they can do to repair their balance sheet is reduce their loan books or sell off assets or loans. And that is happening. And it is going to happen more and more. It is going to be increasingly difficult to get large new loan deals done and that is going to put a damper on the economy. 60% of banks report they are tightening their lending standards. In the recent Beige Book, the Fed reported that all districts have seen tightening standards, something that is unusual.

Leverage loan for mergers and buyouts have dropped 75% since last year. They were only $50 billion in the first quarter, and it is almost certain to have dropped to even lower levels this last quarter.

[My note: In an intelligent move, CalSTRS, one of the best institutional investors in private equity, decided to invest just $250 million into Blackstone Group's newest private-equity vehicle, a rollback from the $1.7 billion it committed to the firm's prior fund.]

And the leverage that was so helpful as it rose? It is now going to have the opposite effect. If you lose a billion and can't raise the capital, you are going to have to reduce your loan book or sell off assets by (using my analogy) $10 billion. If we have potential write-downs of several hundred billion more, that pain is going to be felt in both the corporate and individual worlds, as credit availability is going to decrease and rates are going to go up.

And the pain may not be abating. While some suggest that we have seen the bottom in housing and the economy, the data out the last three days suggest that is not the case.

Specifically on foreclosures, Mauldin adds the following:

Phillippa Dunne (The Liscio Report) sent me this note a few moments ago:

"The MBA delinquency numbers just came out. In Q2, foreclosures were started on 1.19% of outstanding mortgages, up from 0.99% in Q1, and nearly three times the pre-2000 record. The total stock in foreclosure was 2.75% of all mortgages, more than twice the pre-2000 record. Seriously delinquent (90 days or more, plus those in foreclosure): 4.50%, also more than twice the pre-2000 record. Most of the previous records were set in the 1980s, when both unemployment and interest rates were considerably higher than they are now."

If 4.5% are 90 days or more behind, it is likely that foreclosures will rise precipitously. If you think there is a crisis today, just wait six months. Mortgages past due by 30 days are more are now at a nose bleed 6.35%

Think about this. Freddie and Fannie guarantee 50 times their capital in mortgages. What would a 2% default rate do to them? 8,000,000 homeowners now have negative equity in their homes as of the end of the first quarter. That number is rising as home values drop.

Some cheered the fact that home sales rose last month, and that is a good thing. But the number of homes for sale rose even more. There are now 11.4 months of inventory in the existing home market. New homes show an inventory of over 8 months versus an industry norm of 4.3 months.

As I have been saying for almost two years, the housing market will not normalize until some time in 2010. It is going to take a long time for the markets to work off the excess inventory.

Just how much worse can the housing market get? For this we have to go straight to the expert, Yale University professor Robert Shiller, who in a recent interview stated that the drop in house prices could get worse than the Great Depression.

Why should investors pay attention to Shiller's dismal scenario? Because, eight years ago, he famously called the top of the stock market in his book Irrational Exuberance. Then, a year before the housing bubble peaked, he predicted the colossal bust we are now experiencing.

Moreover, along with Wellesley College economist Karl Case, he developed the Standard & Poor's/Case-Shiller home price indexes, which has become the United State's most authoritative source for home price trends.

In his new book, The Subprime Solution, Shiller observes the following:

  • Home price declines are already approaching those in the Great Depression, when they plunged 30% during the 1930s. With prices already down almost 20%, it's not a stretch to think we might exceed that drop this time around.
  • There are about 10 million homeowners whose debt is higher than their home value, which has broad implications for how Americans feel about their wealth and spending habits.
  • The current hopeful consensus -- that house prices will bottom soon and then begin to recover -- is most likely a dream. Housing markets don't usually have "V-shaped" recoveries. And even if house prices stabilize in nominal terms, after adjusting for inflation, most homeowners will continue to lose money.
Importantly, the decline in home prices will not only punish those who can't keep up with the mortgage payments and are forced to sell their houses. It will hit consumer spending (via the reverse wealth effect), and it will wipe out the home equity of tens of millions of Americans. It will also take a long, long time for house prices to recover, especially after adjusting for inflation.

Shiller's outlook on the housing market is far more pessimistic than the current consensus, and unlike the forecasts of many analysts, it's also supported by a deep command of the facts.

He recently wrote a brilliant article in The Antlantic Monthly, Infectious Exuberance, where he discusses why financial bubbles are like epidemics and why we should treat them as such:

Many culprits have been fingered for the housing crisis we’re in today: unscrupulous mortgage lenders, dishonest borrowers, underregulated financial institutions. And all of them played a role.

But too little attention has been paid to the most fundamental cause, the same one that was at the root of the many booms and busts that Sakolski chronicled years ago: the contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they’re going to keep forming. And unless we apply that understanding to the bubble we’re trying to recover from, we risk calamity.

Bubbles are a lot like epidemics. Every disease has a transmission rate (the rate at which it spreads from person to person) and a removal rate (the rate at which those individuals recover from or succumb to the illness and so are no longer contagious). If the transmission rate exceeds the removal rate by a certain amount, an epidemic begins.

And given yesterday's news, this really got me:

Few people seem immune to boom thinking. The recent bubble grew so large partly because the very people responsible for the financial system’s oversight came to share the general public’s rosy expectations. They may not have believed as fervently in the boom, but they still accepted the idea that it would not end badly. Builders kept building, and ratings agencies did not temper their sunny assessments of mortgage securities until after the crisis had begun.

In October 2006, Frank Nothaft, the chief economist at Freddie Mac, a major securitizer of home mortgages, told me that Freddie Mac had financially modeled the impact of a price decline of up to 13.4 percent. When I asked him about the possibility of a bigger drop, he replied that such a drop had never happened (at least not since the Great Depression)—and he seemed unable to imagine that it could.

Professor Shiller correctly points out that the crisis has spread to other market segments:

Already, the crisis has infected other sectors besides housing. Credit-card and automobile-loan defaults have been increasing. The credit ratings of municipal- bond insurers are being downgraded, and the market for corporate debt is troubled. If housing prices keep falling, the impact of the crisis on the broader economy will be amplified further.

Both Sweden and Mexico experienced severe recessions after profligate mortgage-lending booms in the early 1990s. Japan suffered a “lost decade” after its housing bubble burst in 1991. We may wish to think of the current economic setback as a one-act play, soon to end, but it could be only the first act of a long and complex tragedy.

As part of the solution, he argues that we need better information on illiquid markets:

We also need to get better—and more—information to more-sophisticated investors and financial professionals. In real estate, one important way of doing that is by further developing the financial market rather than focusing only on regulating it or reining it in. For instance, real-estate futures markets, which have existed since 2006 but are still in their infancy, have the potential to tame future housing bubbles. Without them, there is no way for skeptical investors who think they see a rising bubble to express that opinion in the market, except by selling their own homes.

If futures markets grow, then any skeptic anywhere in the world could profit from a bubble in, say, Las Vegas, by short-selling real estate there. Substantial short-selling would reduce bubbles, and provide information to home builders, ratings agencies, and others. In turn, builders, for instance, might not overbuild if they see that most of the money in the futures markets is being bet on price declines.

He ends this extraordinary article with a dire warning:

There’s another, more urgent reason to focus on the idea of social contagion today. Like booms, many busts are magnified by group thinking. And once busts become severe enough, they prompt changes in the national mood that ramify well beyond economic affairs.

Benjamin M. Friedman, in his 2005 book,
The Moral Consequences of Economic Growth, cites abundant historical evidence that when economic prospects look bleak—especially for long periods of time—intolerance, racism, and other reactionary impulses flourish. As more people experience hardship, trust between them tends to diminish, and the social fabric itself seems to fray.

If home prices keep dropping, more bailouts of banks and broker-dealers likely will be necessary to prevent the paralysis of the financial system and a severe loss of confidence in our economy and economic institutions. And if we aim to stop foreclosures, with all their ugly consequences, from spreading further, many, many homeowners are going to need loan refinancing—which will need to be provided or backed by the government.

Bailouts of investors and prospective bailouts of unwise or unlucky home buyers have stirred a lot of controversy, and indeed, financial bailouts are, for many reasons, unsavory. But given the severity of the current financial seize-up, they are needed—not to prop up Wall Street profits or housing prices, but to prevent a fundamental loss of economic confidence and to maintain a sense of social justice for those of modest means. Losses of confidence and trust can mount with surprising speed, and beyond a certain point they become very difficult to recover from.

We recently lived through two epidemics of excessive financial optimism. I believe that we are close to a third epidemic, only this one would spread irrational pessimism and mistrust—not exuberance. If that happens, our economic problems will become much worse than they need to be, and our social problems will multiply. Only if we heed the lessons of the boom can we keep the bust from causing lasting damage.

I hope that governments around the world will finally recognize the enormity and severity of this financial crisis and take coordinated measures to limit the damage.

My only fear is that "free market" ideologues still reign, thus ensuring that this crisis will get worse and possibly develop into another Great Depression.

***Update (07-09-08):

An entry in the Alea blog, In Defense of Credit Default Swaps, caught my attention. This response pretty much sums up my feelings as well:

  • # 1 barry Says:

    We are actually seeing a perverse version of ‘negative economic interest’ — the government intervening to protect the sellers of protection at the cost of equity holders. In the case of BS (Bear Stearns) and now, apparently, in the cases of FNM and FRE (Fannie and Freddie), the U. S. government will wipe out all equity holders and even inject capital to save bond holders to avoid CDS triggers.

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