Where Does Too Big to Fail (TBTF) End?
A long time ago I gave up the ghost (not Gawainsghost!) on any discussion of moral hazard and all the ramifications, seen and unseen, of overextended government actions. Luckily a bizarre circumstance has surfaced that brings those ideas back to the front burner and perhaps now will get another look.
You all know the story; there are quite a few firms of various sorts that are too large and too interconnected to be allowed to fail or the entire Milky Way Galaxy will suddenly fall apart. Due to this cataclysmic possibility governments the world over have stepped up to make open ended commitments to these kinds of firms regardless of how badly they performed. Not exactly a good bedtime story.
Forget for one moment how TBTF is applied, at times this can mean an insurer like AIG, and other times it can mean an automotive finance arm like GMAC. The rules are amorphous and we are too stupid to understand these things anyway.
Instead I want you to think about the following example and see that the mess that we have been dragged into will never have any bounds.
Thursday morning I caught the following story:
RBS Board Threatens To Quit Over Bonus Limits
The story details threats by the board of RBS to quit unless they can offload about 3 Billion in bonuses. Later in the day it seems that the UK's Gordon Brown (Mr. Gold Sale) said "too bad so sad" to the board:
UK Prime Minister Gordon Brown Tells RBS To Shove It
but we will have to wait and see what happens.
Remember last week a similar story was written about AIG. Bank of America (NYSE:BAC) is repaying TARP in large part to become removed from pay restrictions. Goldman Sachs (NYSE:GS) has a powerpoint presentation ready to show why their guys are getting paid more than ever this holiday season.
So now my question is this:
If a firm is TBTF, how much leverage can the employees of said firm employ to enrich themselves via bonuses/bigger paychecks/outright theft?
And here is where hasty moves and a lack of thinking bites you. If all of AIG's employees stuck together and demanded they all make 3 million a year (do they already?) or they will all walk and AIG will fail, what can the Fed/Treasury/Government do? Let them walk? Pay them? Who knows. The point is we should not be in a position where my writing this ridiculous example is anything more than comedy. Instead it is a serious item for discussion. Please weigh in.
How Much is the Fed Suppressing Mortgage Rates?
In a tale that goes back quite a while and holds some personal interest for me there were some grumblings Thursday regarding just how much Fed purchases of MBS has suppressed mortgage rates over the past year. Some history;
On September 22 this year I penned a missive titled "Corrupted Data Sets". In the post I took aim at claims by Calculated Risk that Fed MBS buys were a "minor" effect on rates as absurd. This was the start of my move away from CR analysis, but allow that date's story to fill you in:
Corrupted Data Sets
I have been reading Calculated Risk for over 4 years now. The quality of the site is unmatched and the insight offered is top notch. As of late I have noticed something of a change over there (maybe you have too?) where the author has been ignoring key aspects of government policy and looking only at data as if the data itself exists in a vacuum. Now I am not going to pick on CR here, I really cannot fault his logic in the post in question, but I can argue that the omission of serious factors colors the data.
So what am I talking about? From September 17th CR writes:
The Impact on Mortgage Rates of the Fed Buying MBS
There are some charts worth a look. His summary:
I think the impact on mortgage rates from the Treasury purchases is minor. This suggests to me that mortgage rates will rise by about 35 bps, relative to the Ten Year yield, when the Fed stops buying MBS.
How is that for a whopper? "I spent 1.3 Trillion on MBS and all I got was a 35bps rate reduction" does not quite fit on a T-shirt.
There is more in the relevant section of that article.
Later, on October 29, I returned to this same item again in a post titled "Distortion of Economic Information" which is very similar to the last title. I wonder why? (Sorry for the long repost section, but very relevant):
The Distortion: Through the purchase of the worst of mortgage assets, the Fed had hoped to reignite lending. Instead they were inundated with sellers looking to offload MBS, and the banks never returned to the market. The Fed used all the tolls available to maintain all time low rates for mortgages even though the real rate is much, much higher.
Results: Even in the face of this kind of effort, the results have been weak at best. Sales are still poor and only yet another program, the home buyer tax credit, was able to generate much interest. Underwater homedebtors are doing the smart thing and giving up, not rolling into a low rate mortgage set up for 50 years on a home they are under water on.
Future Issues of Distortion: There are many, so a list is in order.
-The Fed's 1.5 (or whatever) Trillion dollar MBS purchase program has been credited by many bloggers I respect dearly (Calculated Risk among them) with lowering mortgage rates about .30 bps. So if the Fed helped rate is say 4%, without the program mortgage rates, by their thinking would be 4.3%. I reject this outright as insane. If true, then two things are also true:
-the use of this money was a poor waste of taxpayer funds and increases risk for the Fed exponentially
-there was no real gain; .3% will not make one iota of difference in the long run. Not one bit of difference. At all. They clearly have lost it.
With banks charging 30% annually for credit cards, I have no idea what a Citi (NYSE:C) mortgage may cost. I think it may be a hair over 4% though. What this boils down to is that the Fed will be hard pressed to exit this program.
If mortgage rates moved up from the federal sweet deal of 4-6%, up to banking world rates of 7-9% (low end in my opinion) this will wipe out 20-30% of a homes price right off the top. Whether you think home prices are rising or not, they are not rising enough to cover that spread should rates return to anything near normal. This is a key point.
That is a lot of things to scan through, but I wanted the proper context for today's post.
While scanning around Thursday I stopped over at Calculated Risk because I had seen a WSJ piece which covered this very topic. I was a bit relieved to see CR covering it as well. Here is CR's take:
Fed's Sack: MBS Purchases Lowered Mortgage Rates by 100bps
From the WSJ Real Time Economics: The Fed’s Market’s Guy Eyes Asset Sales and Rate Increases (ht Paul)
'Brian Sack, who runs the markets group of the Federal Reserve Bank of New York, spoke to the Money Marketeers of New York University ...
Mr. Sack’s group estimates that the Fed’s purchases of $300 billion in long-term Treasury securities earlier this year helped to push yields on 10-year Treasury notes down by about half a percentage point. ... Purchases of mortgage backed securities, he says, pushed those rates down by a full percentage point.'
This is significantly higher than my estimate of 35 to 50 bps and suggest mortgage rates might rise sharply next spring (the MBS purchase program is scheduled to conclude by the end of the first quarter of 2010).
Update: Apparently Sack's might have been referring to the decline from the peak of the panic (not clear from the brief excerpt). Of course the purchases started in January - months after the peak of the panic - and that isn't what people are interested in.
A bit of a qualifier at the end, but I was glad to see another take on this topic.
Another view of the same speech takes into consideration both MBS buys and Treasury buys which mess with spreads many ways. From Mortgage Insider:
Big Mortgage Rate Jump Coming in Spring?
Sack’s group estimates the Fed’s $300 billion in Treasury purchases helped push down rates on those securities by half a percentage point and its purchasing of mortgage-backed securities (it will eventually buy $1.25 trillion) is pushing down rates on those securities by a full percentage point.
If he is correct, then when the Fed stops buying MBS on March 31 it is possible that the jump in mortgage rates will be higher than the 25 to 50 basis-point increase some economists have predicted (there are 100 basis points in one percent). Of course, knowing this the Fed may once again extend its purchases of MBS, keeping rates artificially low.
He also argued that the Fed’s buying of Treasury securities could be pushing up prices of risky assets. Here’s more from the Journal’s Real Time Economics blog:
'It works like this: As the Fed drives down yields on Treasury bonds and mortgage backed securities, investors bid up the prices of other assets, like corporate bonds and equities. (Sacks) goes on to say the Fed may some day need to raise short-term interest rates “further than would otherwise be the case” to offset the potentially powerful portfolio balance effects of these holdings. (Plain English Translation: If the Fed’s fast-growing balance sheet creates a lot of froth in the markets, the Fed might need to raise interest rates aggressively.) An alternative would be to dump the holdings. He doesn’t advocate either approach, but lays out the arguments for them.'
Back in Finance 101 in business school, I was taught that the present value of a security is calculated by dividing anticipated income by a certain interest rate — we could say a risk-free rate plus a risk premium. Well, if the government is lowering the risk-free portion then we can expect people to be overvaluing the security — in this case I mean the risky asset he is talking about such as the stock of a company. (Please excuse my oversimplification of the PV formula.)
I stand firm that the following policy experiments on mortgages have caused a severe distortion in mortgage rates against what those rates would be in a real market:
-Fed MBS buys
-Fed Treasury buys
-FNM/FRE stuffed to gills with mortgages over last 6 months
-FHA about to bust after taking up the slack
-US government bought over 90% of all mortgages last 3-4 months
If anyone thinks after all of the above that a BAC mortgage in 6 months after all these things wind down (in a dream world) will be only 35-50 or even a 100bps higher than now you are as off as can be and are no longer making judgements on reality, but applying half measures using false inputs and pretending they are real. You are party to extend and pretend by doing this.
Economic Disconnect does not pretend.
If you need yet another example of the kind of fantasy land we currently live in, take this great find by the blog Housing Doom which shows how far things are going with no oversight or debate:
Another Treasury Bailout to Assist First Time Homebuyers
This is today's MUST READ, and I strongly encourage you to read the whole thing, but I will excerpt the most relevant hook:
"We didn’t have anyone purchasing the bonds at a competitive rate so now the U.S. Treasury has agreed to purchase them," said Patricia Braynon, director of the housing finance agency for Florida’s Miami Dade County. "It will generate an artificial market."
This madness has to end and anyone not willing to confront reality is playing the same games as the Fed/Treasury. Who wants to play with them?