Economic Crisis Is Largely a Problem of Confidence

by: Dirk McCoy

Observers of this economic crisis are well aware of falling home prices impairing derivative values impairing bank balance sheets impairing lending capacity impairing economic activity- further impairing home prices. And home sales remain depressed as homeowners and bankers are loathe to sell at a loss. As Vikram Pandit stated before the House Financial Services Committee on Wednesday, you can always "sell a $100 bill for $1", but that would not be consistent with his duty to protect the interest of his shareholders.

This is reminiscent of the classic "chicken and egg" problem - which is first, recovered home prices/derivatives or recovered bank balance sheets/economy? The answer is the farmer, who must decide how many chickens he wants and plan appropriately. And the farmer, in this case, is Mr. Obama's Treasury Secretary Geithner, whose announcement Tuesday showed he has a way to go to come up with a plan. This is a bit disconcerting, as he can determine the level of home values, derivatives, et. al., and investors are wondering where these levels are going to be set.

The deflationary outcome, kicked off by 18 Fed rate increases between 2004 and 2006, would have been widespread foreclosures, defaults, and bank insolvencies, and market clearing at pennies on the dollar. 50% would be optimistic. The hyperinflationary outcome would have involved quantitative easing, with a relatively quick recovery to near previous values, perhaps with $5/gallon gas. This has not yet occurred, as the trillions injected, and perhaps to be injected, have been sterilized. It is clear this Fed and government have settled on seeking moderate valuations, or as Mr. Geithner put it Tuesday, "fair and realistic" - a happy medium that prevents the economy from losing supply power yet punishes the most grievous offenders who lied to get loans, made loans without concern for risk, and created insurance transactions without concern for the ability for that to be made good in a worst case scenario.

So, what is "fair and realistic"? Certainly not $1 on $100. And not $100 (or $110) on $100. 80%, 90%, 50%? And how soon?

Somewhere in our past, 20% down evolved as a conservative requirement for a downpayment. Theoretically, if your loan was 80% of your home value, you were safe. Thus, it seems that recovery to values of at least 80%- where homes are actually selling at that level while inventory falls- is required to come close to building confidence, with intermediate steps to slow foreclosures and loosen regulatory mark to market repercussions. Given the regional disparities in losses, 85% would be a better target to build confidence on a wider scale. This will mean some regions will have healthy sales while some have slower sales, but if houses are selling at these values, the market can clear sooner than later. At that point, people can have confidence in the system again, and economic growth can resume. Many derivatives will still be under water, and consequences and punishment will need to be meted out to counterparties, rating agencies, and purchasers that profited from understating the risk. While it's reasonable for an insurance company to be unable to cover losses during wartime, it's not unreasonable to expect them to cover a 20% loss, is it?

Confidence will not come via cramdowns- confidence in contract law remains critical. Requiring Citi (NYSE:C) to break its Citifield deal, in the absence of renegotiation or bankruptcy, would also be a bad step in this regard. Nor will confidence be created via artificial demand of a short term nature, especially if capacity to meet short term needs (say, in climate research or US steel) is created only to later turn to excess. Monetary stimulus would allow the invisible hand of the market to direct resources where best used. While inflation is a possibility, there's no reason that money should not have a half-life in addition to time value.

The current crisis is not just a financial problem to be solved by financial solutions, but more so a confidence problem that requires a confidence building plan. The American people voted to install Mr. Obama, and his appointment, Mr. Geithner as the farmers. They've told us they're working on a plan, we need to know how many chickens they want.

Disclosure: long DXO