Toxic loan modifications

There has been a big push to address the current mortgage crisis via mortgage modifications, notably by Sheila Bair of the FDIC. For most borrowers, modding down loan principals to house values generally just recognizes reality; most borrowers either can't or won't pay far more than the value of their house to live in it. However, a lot of mods just reduce interest rates - here's a particularly spectacular million-dollar 1% balloon loan from WAMU. Not only do these mods not acknowledge reality, they are adding to the toxic debt problem.

A big part of toxic debt, and arguable the worst for the financial system, is debt which cannot be accurately valued by any method. This can arise from exceedingly complicated derivatives, but a relatively new problem arises from our being in uncharted economic waters. Predicting the value of a long-term security requires projecting the future, which in turn must be done with models from the past. However when you're in a strange and unprecedented situation, old models aren't going to be accurate. This means long-term securities become un-valuable - nobody can figure out what they're worth. Since market mechanisms are just an opinion-averaging system, market prices are as arbitrary and meaningless as the unfounded opinions they're based on.

When you have this "mystery meat" toxic debt, it becomes impossible to fix companies reliant on it, even with unlimited resources. There's no way to know how much to allocate to cover losses. Too little means the company is still bad. Too much is an unfair windfall. And almost any amount could be either - there's no way to know, except to wait and find out.

This WAMU balloon loan is exhibit A for a "mystery meat" toxic debt. What will currently overpriced houses be worth in 5 years? We have no idea, basically. How much of the underwater amount will the borrower be able to cover? We have no idea. How possible will it be to get a rollover loan in 5 years? We have no idea. So, what had been a relatively easy-to-value foreclosure has become a million-dollar slug of toxic mystery meat which has to molder on the plate for years until it can be resolved.

Instead of the garbage getting taken out, it's been added to the food. We are worse off than before. I'm all for constructive loan modifications, but these kinds of mods have to stop.

A disturbing aspect of Obama's economic plan

There's nothing on mortgages, foreclosures, bank management, bailouts, deriivative tangles, SIVs, or any of the other financial issues dragging us into depression. This site came up as soon as Obama assumed the presidency and doesn't appear to be pulling punches, as Obama did during the transition. Other issue pages put forward a clear, if somewhat mild, center-left agenda in basic agreement with his campaign promises. So Obama has at least not yet figured out how to address the real economic problems, not even to the point of putting out an outline.

These problems are thorny but they will not wait. It's very concerning that Obama does not yet have a road map he's willing to publish, and possibly no road map at all.

Bank of the Fed Expands; Is Nationalization Imminent?

Yesterday the Fed announced, not one, but two major lending programs: 200 billion for consumer credit and 600 billion for mortgages. This is the Fed moving further into the "Bank of the Fed" approach I advocated during discussion of the TARP bailout. The Fed is effectively taking "deposits" in the form of Treasury bill purchases and using the money to make loans to private entities. The loans are currently being made indirectly, by supports to private bank lending, because the Fed lacks the infrastructure to evaluate individual loans.

This has engendered a lot of concern about wasting money and crowding out private lending/borrowing; of which some concerns have made it to the mainstream media. These concerns are legitimate; during the TARP controversy I was particularly concerned with the Fed crowding out essential lending to make wasteful loans. However, I think at the moment there's just no choice. For whatever reason, banks are unable to convert virtually free money from the Fed into consumer and commercial credit except at exorbitant rates. We need credit for our society to function and apparently nobody but the Fed can do it.

Lending by the Fed, though, may very well drive what's left of the banking system out of business. The Fed has access to unbelievably cheap money; at this writing it can borrow for 3 months at a rate 0.04% (free, essentially) and for 30 years at the astonishing rate of 3.52%. There's no way private banks can compete with that. If the Fed loans to some people but not others it is effectively providing an enormous subsidy to the favored and will create monster distortions in the economy. In addition, the Fed will face severe political pressure, as we've seen with the attempt to give away the farm to the banks while the auto industry gets crumbs. So I think the Fed will have to be relatively even-handed in its lending, and this is going to leave the Fed dominating most lending much as Fannie and Freddie now dominate mortgage lending.

So in the very near future we will likely have a de facto nationalized banking system, with governmental standards determining who does and who does not receive loans. Good or bad, it's now basically inevitable since the private banking system used the freedom provided by deregulation to go out and commit suicide. It is truly ironic that the mad drive to deregulate of the past 25 years will lead to socialism on a scale not even considered seriously in America before. But, that's the situation, and we now have to start thinking about how the government will run the bank.

The Blogosphere and the Crisis

Obama recently released his list of economic transition advisors and it's a real disappointment. Everybody is extremely middle-of-the-road mainstream. There are few who recognized the housing bubble before it popped and none who protested Greenspan's ultra-loose money policy which helped set it up. Many are from banking or the Clinton adminstration and involved in the regulatory changes that helped set it up.

So, while it's a group of competent workmanlike team members, it lacks anybody with the foresight to see the current crisis in advance. The puzzlement is that there's a large group out in the blogosphere which was far ahead of the curve in foreseeing this crisis. The star of course is Nouriel Roubini, whose far-out 12-step collapse process, ridiculed when it came out, has been pretty spot-on as a set of predictions. But almost any of the big economic blogs - check out Calculated Risk's links - has been ahead of the curve on this. So why is this large reserve of foresight, including academic heavyweights like Roubini and Krugman, unrepresented on Obama's transition team?

I am leaning to the idea that at this point being right isn't going to be enough. A lot of the more intellectual types (which would include me) tend to think that if you're publically right people will eventually start listening to you and implementing your ideas. But the current situation is about as much of a push for the "no more bubbles" policies advocated in the blogosphere as you could have asked for, and we're not seeing a thing. So it seems we need to connect with some kind of political movement as well. I'm not really sure how, because the "reality-based" blogosphere ideas seem to cut across party lines, based on the fight against the TARP. But I think it's something to start working for.

Europe Starts Facing Reality

Several European governments today pledged 1.3 trillion Euros to fix the banking problems affecting their banks. In combination with the recent blanket banking protection from Britain (not yet explicitly valued but quite large) they have now offered to cover more than 2 trillion US dollars in losses. This action means the European governments have, roughly, promised enough to fix the problem on their end. The US and Japan should be able to manage interventions on similar scales to match the worldwide problem. We now have several remaining problems to deal with:

1) What about the non-EU countries, and the countries that everyone knows can't cover their commitments? UBS and the Irish banks are still exposed, as well as many smaller banks in East Europe. We still have major busts to come unless the EU acts as a whole (and why would they bail the Swiss?)

2) Can the world provide the borrowings the governments now need? In a sense they can, but I stand by my prediction they will have to borrow long for this and so long bond rates will soar. In principle, I think this is a better way to get to the "rebuilding" state than a classic panic; but the losses and the need to rebuild remain real. To put things in context, the Swedish action, which involved the injection of only 4% of GDP came with a 6% drop in GDP. Just today's intervention is 250% as much as the Swedish. Much is in the form of deposit guarantees, which obviously won't all have to be paid out, but a recession far worse than the mid-70's recession is probably unavoidable.

3) What about the shadow banking system? They aren't covered. IMO it's good ethically for the hedge funds to go down while the classic banks are protected but we'll still see a lot of damage. One good thing about that is that hedgie collapse may provide enough financial losses for the governmental interventions to fix the rest without strangling the economy. Still though, those losses will hurt.

4) Will they clean up the banks and stop the bad lending? That's necessary to get a Swedish result (bad recession followed by recovery) rather than a Japanese result (recession without end). Initial indications from Fannie/Freddie and the UK is that the governments will continue to force lending on houses, which is a very bad sign.

All in all, this permits a controlled clean-up and will probably protect the world from uncontrolled side effect disasters like rumored halts to world shipping. However, we know will find out how competent and prompt the clean-up is. And the real losses must be faced, no matter what we do.

Raise the Fed Funds Rate: The Old World Order has Returned.

Right now sellers of credit won't sell to purchasers at the current price (interest rate). Were this any other market, economists would immediately say that, given the current supply and demand, the price is too low and prices (interest rates) should be allowed to go up. That was the recommendation for Soviet Russia grocery stores with their infamous lines. Increased prices reduce demand, increase supply and bring the market back into balance.

For over 70 years, however, the action of governments to credit crunches has been to increase the supply of credit by liquidity interventions. This was due to the fear of exacerbating the economic slowdown that inevitably accompanies a credit crunch. It has been so universal, and practiced so long (there is scarcely an economist alive who can remember any other way), that "increase liquidity" is a reflex response of all economists to a credit crunch. Economists have essentially forgotten that when supply is short and demand is set there are two possible actions; raise the price or increase the supply, and that normally economists recommend raising the price over increasing the supply directly.

Central banks, and the governments that back them, are mighty entities with great capacities. But like all human institutions, they have their limits. We have all become so used to the idea that governments can fill the credit supply shortfall created by low interest rates that we have forgotten they have limits and cannot supply infinite credit.

The current credit crunch has been caused by a truly massive worldwide destruction of financial capital. I have often read claims that the US housing bust, identified as the cause, isn't big enough to justify this. But there is much more than just a bust in US housing. There have also been massive real estate bubbles in many European economies, including England, Ireland, Spain, Poland, the Baltic states, and an old bubble in the Netherlands kept propped up for years. There is a major property bubble in China. There is a LBO bubble in most of the Western world, as well as extensive retail and hoteling bubbles. There is a large auto bubble in the US and large credit bubbles in the US and many other countries. Many have not yet gone bust, but the wise know at least most of them will, with vast additional losses.

I believe the losses simply exceed the ability of the current government to generate and reallocate capital. If so, no possible liquidity intervention will be able to hold credit prices to their current very low level (many real interest rates in the US are actually negative). Therefore, while governments should continue the current aggressive provision of liquidity, they should now raise interest rates until markets can once again clear given that additional (effectively subsidized) liquidity.

I say this is a return to the Old World Order because when currencies were meaningfully backed by gold and silver, governments were stringently limited in their ability to lower rates and create capital by the threat of specie flight. In those days, when a panic hit, interest rates had to go up. That Old World Order is now back; even with the considerable latitude provided by fiat currencies governments have hit their limits. Our credit is less than we might wish; we must choose which of our many competing targets will get it; and the most efficient way is by market allocation, which requires increased interest rates.

We can tolerate high real interest rates. Ask Paul Volcker. But we cannot tolerate failing credit markets. Our policymakers must accept their limits, encourge efficient allocation of limited capital, and restore public confidence by showing they understand this the realities of the credit markets.

(Hat tips to many people I've been discussing credit with, especially to evilhenrypaulson and AngrySaver. Anybody else who thinks they deserve a hat tip or link - tag me.)

What we need for this crisis

We need to examine banks in detail, with fair valuation procedures. After this bank should be immediately recapitalized with enough government capital to keep going, with the government taking an appropriate equity share. The whole procedure should be accomplished as fast as possible. Market mechanisms will not work; revaluation without recapitalization brings disaster; recapitalization without revaluation brings trillions in losses for the taxpayer. Here's why:

In general the markets are very good at allocating capital. But sometimes the markets can go very awry, and it's possible for a central planner to surpass them. As I've expressed in my Naked Capitalism upgraded comment, I think *Paulson* will be substantially worse than even a deranged market, but that might not be true for a wiser Treasury secretary.

Markets inherently cannot correct for a major malinvestment of financial capital. Financial capital represents in the real world actions and resources allocated for coordination - obviously a very important thing. If those resources or lost via malinvestment they must be replaced, which requires high relative interest rates for financial investments. However, the losses mean that current financial investments are overvalued, which requires low relative interest rates to correct. So the market can't correct the problem.

The solution, then, must be imposed by non-market cooperative activities, which on this scale means government. The correct action is to force immediate write-downs of the bad assets and then to force recapitalization by having the government provide the capital, implicitly backed by its taxing authority and ultimately its legitimacy and guns.

The write-down could be accomplished by a Defazio-type plan (bank examiners) or approximated by a devaluation. Recapitalization could be done by a bazillion plans although I think in the context of American politics preferred stock purchase (as suggested by Stiglitz, Krugman, and many others) is the way to go. Note that you have to take *both* actions - one alone leaves part of the problem unfixed.

To be fair, if you do one, then the market *can* do the other. So if you do a DeFazio plan, real interest rates can soar to draw in capital. If you do only Stiglitz/Krugman, they can collapse to erase the post-recapitalization value of financial investments. From the viewpoint of the taxpayer, Stiglitz/Krugman without DeFazio is thus a bum deal, although it will repair the economy.

I think the reason there's near-unanimity in the blogosphere on the idea of "write-down and recapitalize", across a very wide political spectrum is simply that, on basic principles, it's the right action.

Bank of the Fed Starts Operations

Amidst all the bad news, there is some good news. The Bank of the Fed is open for business and it's helping a lot. The Fed tripled its working capital duration window on Monday and commercial paper volume in those durations (>20 days) is now running only moderately below the year's averages and about twice the rate of the last two weeks in September. The market has shifted hard to asset-backed paper, which I assume reflects a Fed collateral requirement. In the longer durations asset-backed paper is at volumes far above typical averages while all other CP markets are virtually shut down.

http://www.federalreserve.gov/
re...volumestats.htm

The A2/P2 spread is down, to "only" 2.93. Still twice that of the 74-75 recession, but probably an overestimate since the market is obviously restricted in its ability to handle that kind of paper. So perhaps the market is only predicting the worst recession since 1937 now rather than a depression.

http://www.federalreserve.gov/re...ov/releases/cp/