15 More Thoughts on the Current Crisis

1) Do Fannie (FNM) and Freddie (FRE) deserve some blame for the crisis that we now face? Yes, but not without blaming Congress and the Executive Branch for pushing homeownership far beyond the natural rate of ownership, which I wager is around 60% rather than the 72% that it touched for a brief time.

But here are some ways that F&F went out of their way to help create the current crisis:

• F&F did push loan growth and growth of their retained portfolios in order to benefit their shareholders.
• They bought significant amounts of Alt-A and other lower quality loans for their retained portfolio.
• They aggressively lobbied to protect their position.
• They argued for capital standards that were lower than would be needed in a crisis (so did many financial institutions)
• They lowered underwriting standards in order to meet competition from private lenders. They could have given up business, delevered, and been stronger companies for when the crisis would hit.
• They managed to their GAAP financials. A prudent financial institution manages to a stressed version of their most stringent capital constraint.

Finally, I would add that this was an area where Greenspan was right on policy, along with a few of the more conservative members of Congress. If you are going to have F&F at all, then use them contra-cyclically. When the mortgage markets are lending, F&F should sit on their hands, and let the market do its work. If F&F’s balance sheets weren’t impaired now, they could be doing some real good here, but because their credit quality is suspect, as well as the commitment to their solvency from the Federal Government, their cost of fresh capital is high, making mortgages more expensive than they otherwise would be.

Note the current rise in Fannie 30-year mortgage rates.  This series tends to peak out at 6.20% but I am expecting rates to exceed that and soon.

Personally, I don’t think the government should be in financial businesses. Government agencies tend to overlend, and lend to bad risks with insufficient compensation. Then again, I don’t think governments should be in the money business either; they abuse the privilege, stealing from us in the process.

2) Will contractual terms be honored by the courts? Some hedge funds will press for their rights. My guess is that they won’t win in this environment. The system has a tendency to fight individual rights in a crisis. But, there is no free lunch. To the extent that contractual rights are infringed, rates will rise when lending resumes to compensate for expropriation risk.

3) Get financing when you can, not when you have to. Others have pointed to this post, but it bears repeating. The banks ran for too long on capital bases that were too slender. Now they are paying the price. The only pseudo-equity capital available is that from government sources.

Now, there may be a competition for that capital from the government, and perversely, it might lead to banks using the capital to buy other institutions (PNC has already done it to Nat City), rather than make loans, and on net, I would expect that to result in still fewer loans being made than in the absence of a merger. So let the competition begin for who can gobble their cheap competitors with cheap government capital.

4) Away from that, the Fed is having a hard time controlling Fed funds since they started paying interest on reserves deposited at the Fed.

Though I have written on the changing balance sheet of the Fed and its implications, Jim Hamilton of Econbrowser has a very good post on it as well. The only place where I think we differ is that I think this will eventually be inflationary to goods prices when the Fed is forced to stop sterilizing.

5) Now the Fed is in the business of short-term unsecured lending to corporations via buying CP. (I think this will help lead to the first real CP default since Penn Central.) Early indications are that CP funding costs are higher than before the crisis if CP is funded by the Fed.

6) Never buy something you don’t understand, unless you have a friend who is smart and trustworthy by your side to advise you. Many municipalities got bamboozled by investment banks in much the same way that homebuyers got swindled by those offering subprime loans. Through derivatives, they offered a way to lower the current costs of debt by having the municipality sell options against their position that would force costs higher under certain circumstances which seemed unlikely, but were more likely than not.

The same is true of many investment products created by Wall Street for retail investors.  Sell them something that offers a high yield with safety, subject to some options sold short that are unlikely to come into the money.  I see it often. Don’t buy complex structured products from your broker. Odds are they are taking you for a ride.

7) Those who have read me for a long time know that I think GM and Ford (F) are eventual zeroes for the equity, and the subordinated debt.  Even the senior debt will get whacked severely.  There is no value in corporations that have huge promises to their employees way out into the future, when competing against better capitalized and better run foreign competitors like Toyota (TM) and BMW.

So, don’t bother trying to rescue them.  Rather, let foreign competitors buy them out, if they want them.  That will be a good test as to whether there is value there or not.  Possible foreign buyers have worked under the assumption that the Big 3 cannot be bought.  If the US sends a message that they can be bought, would any of them be bought?  My answer is no, unless the US Government or the PBGC sweetens the pot.  Other notes:

• Daimler thinks Chrysler is a zero. (no surprise here)
• The Treasury should give up on lending to the automakers. (Much as others think they are critical, if the plants are valuable, foreign capitalists will maintain them.)
• The TARP may lend to auto financing arms, but that is probably a mistake as well.
• We should not bail out the automakers, regardless of how politically expedient it is.  Because of the employee benefit promises made, there is no way any US automaker can beat foreign competition.  It is time to let them fail, and let the unions take the rebuke that they royally deserve.
• GM is not too big to fail.  Let them fail, and then expedite the bankruptcy process, so that senior debt becomes equity, the firm goes non-union, and the firm can compete globally for the first time in 40 years.

8 ) Greg Mankiw asks if we have learned enough.  My view is no, we have learned little, and what Bernanke thinks he learned regarding the Great Depression is wrong.  This is not a crisis of confidence and liquidity, it is primarily a crisis of solvency, which drains liquidity.  High levels of total leverage make a financial system inherently unstable, and the only way to cure it is through expedited bankruptcy procedures.  As it is now, Bernanke and Paulson are trying to save the financial system by wagering the credit of the USA.  (My opinion is that our nation is great enough that we would risk another Great Depression rather than give up our liberties to the Government.)

9) A young friend e-mailed me from Lithuania (where she has a semester abroad), and asked me how serious the current economic situation is.  My response:

To give you the quick summary, we may be headed into Great Depression 2.  Or, as I sometimes call it, the Not-so-great Depression.

A Depression is a severe recession where the solvency of the banks is compromised.  Debt levels of financial companies, consumers and our Government have gotten to levels where repayment of debts in full is difficult if not impossible.  The system is overleveraged, and funded by leveraged institutions that could fail if they aren’t paid back.  There is kind of a “domino effect” here, where failures can cascade.

That’s why the Government has stepped in, encouraging financial institutions to shift their debts over to the Government.  That will work for a while, but eventually parties will become reluctant to lend to our Government as it becomes a bottomless pit of promises.  Then inflation of the currency will begin.

This is an ugly situation, one that is the product of sloppy monetary policy, poor regulation of financial companies (for two decades), poor risk controls, overlending by government institutions, and a cultural failure where we borrowed too much and saved too little.

I wish I could be more chipper here, but this is ugly, and what the government is doing is not likely to solve the problems at hand.

10) Slow moves tend to persist, sharp moves tend to mean-revert.  Don’t put much confidence in today’s sharp move up.  Strong one-day upside moves are characteristic of bear markets.

11) My post last night neglected one item.  Stable value funds have more flexibility than many other financial entities.  Be wary if the credited rate drops a lot.  Better to withdraw funds in that scenario, because it implies that the market value of assets is significantly less than the book value.

12) Be ready for a surprise in the GDP data, as I highlighted last quarter.  The implicit deflator for Gross Domestic Product will be extra high in the third quarter because of the fall in energy prices.  Just as it pushed “real” GDP higher in the second quarter, it will exact its pound of flesh in the third quarter.

13) My pal Cody is red hot, and though he is less measured than I am, I agree with much of what he says.  We need to vote out Republicans and Democrats.  We need new options.  Personally, I think we need to radically change the Constitution, and move to have a parliament, where the head of state is the head of the majority party.  That will create government that is closer to the consensus.  Eliminate the Presidency — it is too dangerous of an institution.

As Cody put it today: 2. Real headline today: “White House Encourages Money-Hoarding Banks to Start Lending” – I thought profit motive was what was supposed to encourage banks to lend. And only profits make stocks go up, so why would shareholders want the banks to start lending if the bankers don’t think it’ll be profitable?

I can’t agree more, and the Treasury is pushing on a string if they are trying to force the banks that they have financed to lend.

14) Commercial Real Estate is the shoe yet to fall, yet the CMBS market has anticipated much of the decline.  Are the Fed and Treasury ready for this?  They weren’t ready for residential housing declines.

15) The foolishness that exists today regarding the government buying stakes in financial companies has now transferred itself to policymakers who think the equity market is now cheap, so invest the Social Security surplus in the equity market.  Problems:

• We have always avoided Socialism like this in the past.
• How can a bureaucrat with no profit motive figure out whether this is a good decision or not?  Or, how will the bureaucracy extract maximum value for the taxpayers?
• Is the market really cheap now, or, only seemingly so?  The time to invest is during a baby bust, not a baby boom as it is now.

As with so many of these decisions, the answer will only be clear in hindsight.

Comments

[Jason Rines...:]

"(My opinion is that our nation is great enough that we whould risk another Great Depression rather than give up our liberties to the Government.)"

Exactly. The citizenship was entirely against the bailout, willing to risk a depression to stop the rampant corruption in government.

The majority which are responsibe citizens both Republican and Democratic (We the People) are ready and willing to help one another through it, but the government passing the bill regardless protects those in office this election to remain there.

We do not need a new government system. The system works, the public will identify the culprits in the House of Representatives and vote them out. This has happened 3 times historically after these kinds of financial crisis and it takes roughly four years. Reagan was a good leader as he was in touch with the public, appearing on TV very often and had teams to conduct never ending economic surveys and studies. How do you run your business? With consistent market research. You cannot replace morals of caring for people and doing a professional job with a lack of morals. The Judeo-Christian value system teaches such as our framework for "Liberty" and "Equality" but our focus was on the second principle of Equality. Liberty is about reaping the benefit of one's good decisions and accountability for bad decisions.

In-between the next inevitable voter revolution which many responsible business leaders are encouraging but as mentioned takes time, enjoy the socialism to fix socialism! I am cutting down my work schedule after working 16 hours a day since July of 2007 preparing my businesses for this time. In 2012 I will run for Congress. Fiscal minded fundamentalists like yourself Mr. Merkle should consider it as well. No reason to keep talking about it, unless you wish to do something about it.

2008 Oct 29 12:46 PM

[Larry House:]

Thanks for a lot to think about, even if it is mostly bad. It is time we made some hard decisions and got back on course. It must begin one household at a time. My wife and I are increasing our savings rate, decreasing spending, and paying off debt. Maybe our government will even catch on, but I doubt it.

2008 Oct 29 02:39 PM

[Smarty_Pants:]

"Will contractual terms be honored by the courts?"

They are unlikely to even get to the courts. Can anyone tell me what the result was on the AIG shareholder vote regarding their FED nationalization?

Oh, never mind. They didn't bother to let the shareholders vote. So much for subtle legalities like individual property rights.

I keep forgetting we're a fascist empire now and no longer a democratic Republic. What we need is 'Change' to put our 'Country First' and not be bothered with what any particular individual thinks is his or her Constitutionally protected right.

2008 Oct 29 03:13 PM

[Echo To All:]

I am not a fan of point 8 and 13...

for 8. so we should just pack it in and go home. sit on our hands and watch an unemployment level of some +20%?

i mean, it may be easy for some of u wealthy older pros out there, but for those of us basically just getting started, don't want to hear defeatist talk.

for 13. the economy in europe sucks, has been sucking and will continue to suck due to its inflexibility inherently promoted by the parliament system. So no thank you to that idea.

i just find it funny that the system that made people have a good living can now be questioned by those very people because the system is having a hick up.

2008 Oct 29 03:20 PM

[El Borbah:]

A parliamentry system is the LAST thing this country needs. I am a Canadian living in the U.S. Let me tell you what a parliamentary system does - in a multiparty system, a national party with 35% support concentrated in a few urban areas can have 60% + of the seats. The other thing is a majority government under a parliamentary system is an elected dictatorship. The reason that the U.S. isn't as far along the road to welfare-statism is becasue of the checks and balances the founding fathers placed in this great Repbulic.

In Canada, Liberal majority governments under Pearson and Trudeau - governments which never had a mandate from the majority of the Canadian electorate - have done real economic and social harm to Canada in its push towards a European Welfare state.

The solution, is not in new forms of government, but to enforce the 9th and 10th amendments of the constitution

2008 Oct 29 03:54 PM

[Smarty_Pants:]

echotoall:

If 20% unemployment is what it takes to get back on track then that is the price we should pay. Propping up a failing system only continues to waste resources trying to avoid the painful and necessary correction.

These businesses lost tons of money and poisened the entire financial system providing unneeded products. Why do we want them to keep the doors open when the same money could be used to start profitable businesses providing needed products at lower prices?

Maybe that means some former quant jock has to find a new job driving a forklift and learn to adjust to his new income, but it will be in a stable and profitable industry that is productively benefitting the economy instead of speculating with borrowed money.

Life is hard sometimes. Layoffs happen. I've been laid off twice in my career, but I got through it by tightening my belt and trying harder. Anybody who thinks that they have a 'right' to their job is only kidding themselves. The possibility of losing a job is one reason why people used to save money before we turned into a credit card society.

The rules for getting ahead are older than the hills. Work hard, spend less than you earn, pay cash, avoid debt, and be completely honest. When possible put your money to work in safe investments that earn you a good return.

Over the long run you will do OK. If you are really down and out after all that, you will find people are willing to give you a chance because they will remember the way you acted in the past when times were good.

2008 Oct 29 04:32 PM

[MarvinMBA:]

STATE BAILOUT is going to be the next big thing...Who is going to pay for all of this??? Hyper inflation is my best guess...good luck because we are
really going to need it!! MarvinMBA

2008 Oct 29 05:17 PM

[Moon Kil Woong:]

1) The unions are not the cause for GMs woes. Japan pays their employees more than the US and still make cheaper, better, and safer cars with better gas mileage. The management is obviously the failure.

2) Yes, the mortgage crisis is only a small fall off. With a slowing economy defaults by the general population is possible. When collapsing real estate prices hit the high end and jumbo market then we will know the downturn is full blown and maybe the end is in sight. However, that means lot's of people are broke and even the fake unemployment rate may be 8-10% (real unemployment at like 15-18%).

3) If banks can't handle a mild blow-up of the riskiest ARMs because of CDS and CDO derivatives then they can 0% handle a recessionary blow up of the whole market at large. That's why market are down 50% or more. The US stock market is relatively unscathed right now.

Anyone complaining now won't survive when the market is down 60% in 2009.

2008 Oct 29 11:52 PM

[David Martin:]

An excellent post, as always. I always bookmark your articles.
Here is a further not-so-cheery thought:
Check out the Financial Times for details of the IEA's report on oil prospects. Add in the fact that present low prices mean that the investment in things like the oil sands just are not happening, and in any case the costs will be vastly more than present low oil prices from easy to exploit fields, and it is clear that oil availability will be greatly restricted.
This means that any sort of recovery will almost immediately bang up against an oil price going through the roof, bringing the recovery to a grinding halt.
A real, sustainable recovery will need both present levels of debt to be unwound, together with the jailing of the criminals who have lied and lied again about asset valuations to keep their ponzi schemes going, or they will continue to pillage the system instead of undertaking any real investment in productive assets, and also the replacement of present energy systems.
We are looking at a 20 years, at minimum.

2008 Oct 30 09:26 AM

[ksmithdc:]

Interesting read, thanks!

2008 Oct 30 09:56 AM

[Emerald:]

David Martin has it right. Articles are now appearing that consumers will go back to their old driving habits now that the price of gasoline has declined. Look for exploding oil prices late next year as production declines in Venezuela and mexico accelerate. More oil wars ahead unless we invest in alternatives. Best stock ideas are energy stocks.

2008 Oct 30 10:50 AM

[Frank Stopp...:]

The natural rate of home ownership, which David Merkel estimates at 60%, depends very much on the society. The rate among, say, homesteaders, native Americans, or many traditional tribal societies is more likely around 100%.

The why of 60% is a much more interesting question than the number itself.

Frank Stoppenbach

2008 Oct 30 11:07 AM

[carey_jim:]

Some comments on Social Darwinism.

First, Japan built their great car industry using Mercantilism, better known as the system of protective tariffs and selling more to foreign countries than you buy from them. The United States also built its economy that way during the 19th century.

In some cases, Mercantilism works, obviously. For example, the Harley Davidson Motorcycle company was near bankruptcy when the United States government saved them using tariffs.

Social Darwinism can only carry us so far. For example, the Japanese don't buy American cars because of a complicated combination of tariffs, because of a complicated way of doing business in Japan using "crony capitalism," and because of simple group pressure.

One hundred an fifty years ago, Commodore Perry opened up Japan with force. That was social Darwinism.

Sixty years ago, Hitler started a campaign to take some of the world's natural resources that were being monopolized by the British. After all, he reasoned, the British had taken them by force in the first place, so why shouldn't he honor that tradition by disputing Britain's "ownership" of one third of the world? Social Darwinism.

Five years ago the Bush administration invaded the Middle East to secure its oil reserves.

Paradoxically, cooperation is necessary for prosperity but how can we build a level playing field (free trade zones) where the rule of law obtains and fair play is universal?

All over the world and in the United States there are angry people who have been excluded from the game.

War, protectionism and revolution: Three undesirable aspects of social Darwinism.

2008 Oct 30 01:21 PM

[kebu77:]

A snip from the article - -

"[T]he only way to cure it is through expedited bankruptcy procedures."

Why not the same for homeowners? Justifiable loan mods in both the interests of lenders/investors and homeowners are being frustrated by the structural barriers of the current system, including lender-servicer arrangements skewed in favor of servicers that promote foreclosures over meaningful work-outs that let folks stay in their homes.

2008 Oct 30 02:07 PM

[PainfullyAware:]

Way to go iThikBig - I hope you have some fat cash for your paladin effort. I'll vote for you. You definitely have a better attitude than most of the shlubs currently in office.

I think you should get Smarty_Pants to run as well.

If the world doesn't end maybe I will join you too. My annoyance level is tested daily by those clowns in Washington.

The price of freedom is eternal vigilance.

Dug The Article; great insight.

We may come out of this ahead, despite the governments efforts to the contrary. Lots of people beginning to take notice of the shenanigans.

2008 Oct 30 09:50 PM

[Jason Rines...:]

I am a little more optismistic on the recovery time David. I believe the pain effect will get people to wake up as they have in the past and vote out those in Washington either facilitating this disaster or simply winking at it. History tells me this will occur and this nation and people have the heart and will. Collapsing economy and subsequent pain are the catalysts that remove poor management in business and government. I believe you correct in your over-all analysis that just as we may begin to recover we will see oil prices and other necessary commodities go through the roof.


On Oct 30 09:26 AM David Martin wrote:

> An excellent post, as always. I always bookmark your articles.<br/>He...
> is a further not-so-cheery thought:
> Check out the Financial Times for details of the IEA's report on
> oil prospects. Add in the fact that present low prices mean that
> the investment in things like the oil sands just are not happening,
> and in any case the costs will be vastly more than present low oil
> prices from easy to exploit fields, and it is clear that oil availability
> will be greatly restricted.
> This means that any sort of recovery will almost immediately bang
> up against an oil price going through the roof, bringing the recovery
> to a grinding halt.
> A real, sustainable recovery will need both present levels of debt
> to be unwound, together with the jailing of the criminals who have
> lied and lied again about asset valuations to keep their ponzi schemes
> going, or they will continue to pillage the system instead of undertaking
> any real investment in productive assets, and also the replacement
> of present energy systems.
> We are looking at a 20 years, at minimum.

2008 Nov 03 09:32 AM