Dear Ben and George: Time to Do Something

Dear Dr. Bernanke and President Bush,

As a long-time participant in the financial markets who has watched in dismay as the Federal Reserve and the U.S. government have failed to properly address the unfolding credit crisis, I feel compelled now that we are at the edge of a precipice that is unlike any other that we have experienced since the Great Depression to humbly offer my suggestions on what must be done.

First, there is no way to avert a recession or to prop up equity prices or home prices. You can’t magically make a bad mortgage or loan good. Risking the ire of the heads of foreign central banks by cutting rates won’t help. What is the interest rate that makes sense to a lender such that he is willing to underwrite the risk of failure of a return of principal? It is HIGHER not lower than whatever it was before. That is why the policy of cutting rates isn’t working. And as far as fiscal stimulus, why should we give everyone $800, and, in the scheme of things, is that even going to help? Both of these attempts bring in all sorts of unintended consequences without addressing the main problem: illiquidity due to the lack of a true understanding of the value of derivative securities.

Our financial system is more intertwined than ever, and much of the risk that used to reside on the balance sheets of regulated banks is now distributed broadly throughout the system. With the downgrade of Ambac (ABK) and the inevitable insolvency of the major insurance providers to the securities markets, we will now see forced selling by all sorts of entities, which, in turn, will beget even more selling and create a vicious death spiral of margin calls, capital calls, etc. Worse, this is going to scare the living daylights out of the average American who thought that his or her municipal bond was “AAA”, contributing to potential hysteria.

What can and must be done? Very simply, while it pains me as one who believes that government solutions are suboptimal at best and often disastrous, I believe that the government must resurrect a play from the S&L crisis and create an entity similar to the RTC to buy securities. By providing a floor on the value of municipal bonds, asset-backed securities or mortgages that lose their ratings, the financial calamity of a self-fulfilling prophecy of mass liquidation can be avoided. THE GOVERNMENT MUST STEP IN AND PROVIDE DIRECT LIQUIDITY TO THE HOLDERS OF THESE DISTRESSED FIXED-INCOME AND DERIVATIVE SECURITIES.

This action certainly won’t stop the inexorable slide towards recession and lower asset prices in general, but it will prevent the margin-call meltdown for which we are headed. As the new holder of default risk, the government will then be in a position to use public policy to minimize the defaults that are actually experienced. It is my understanding that many of these securities are worth more than where they might be quoted on the market, but the illiquidity that presently hangs over the market prevents a more realistic price to clear the market. Many of those that would traditionally provide liquidity are unable to do so, while those that are able to provide liquidity (and have done so to some degree) must surely question their vulnerability to an even more destabilized financial system. Over time, it is quite possible that the program could be profitable for the government if default rates come in below the very high projected levels implied by the current prices on the securities.

Dr. Bernanke, I know that you want to restore confidence, and I believe that you have come to see that lowering rates further is like pushing on a string. It unfairly penalizes those on fixed-incomes, as you are encouraging short-term interest rates below the current rate of inflation. President Bush, surely you must realize how inconsequential and inefficient the proposed fiscal stimulus will be. Most Americans will simply save that money rather than spend it. To those who are in severe financial distress, the amount is not significant. Gentlemen, the world is counting on you and your advisors to show leadership and can ill afford to continue to watch as you pursue inappropriate policy responses. Go to the root of the problem for the financial markets and provide long-term liquidity where it is needed most, thereby avoiding the death spiral of forced selling.

Comments

[User 124892]

The Fed should not do anything. Free markets will correct their self's.
Now as for congress, they have run the tax payer into a debt of 9 trillion dollars. They should be tared and feathered, it is a certainty that they haven't done their job. They were sent to run the peoples business, which they have completely failed to do. Congress, your local congressman or woman have let you down again.

[hammerhead]

They lowered the FF rate 75 basis points. In the long run, it will do as much for the US domestic economy as lowering the rates to 1/2% did for Japan's domestic economy (18 years in the tank).

Here are my suggestions:

+ Bring all the troops home from Iraq, now. Local base-centric economies will be rejuvinated, and we might save a trillion dollars.

+ End all ethanol subsidies, and food prices will drop.

+ Mandate a one year suspension of all capital gains taxes. That will get the speculators back in the markets. Bernanke did say he wanted a short term solution.

[GH]

Since you propose spending taxpayer money anyway, I propose instead a more beneficial approach: for the next two years (say), a temporary federal agency can simply buy all foreclosed owner-occupied properties at well-documented owner cost, and auction them at a reserve price of 75% of said cost. If the reserve price isn't bid, the home is instead destroyed (recycling as much of the content as possible), and the lot cleared, thoroughly cleaned up, and auctioned. This directly attacks the current housing over-supply, as well as creating (temporary) jobs doing the demolition, recycling, and clearing. It has myriad positive effects, and few negative ones.

[AlanBrochstein]

I am not so sure that I am proposing spending taxpayer money. The more thought I gave to it, the more I realized that the government's willingness to buy distressed securities at a price would create a floor and encourage private investors to invest with some cushion of support beneath them. In other words, if the government had a standing bid of 25% of face value for these securities (similar to Citadel's bid for E-Trade's loans), then speculators might be willing to pay 30%. These securities are so low in price because of supply/demand issues and most likely do not reflect the true value (which will be based upon the level of defaults). Your proposal makes little sense to me. First of all, there is no over-supply of houses. There is a situation where prices are too high and credit too limited in availability. The supply only seems high because the transaction volume is so low - the number of months is high, the number of units in absolute terms or as a percentage of all housing is not problematic. The problem in the financial markets, though, is quite different. Leveraged entities, including banks, are being margin-called.

[Ezzyme]

Dear Alan,

Please stick to picking stocks and calling markets. I'm in awe of your recent calls.

The RTC was a disaster. One of the biggest waists of taxpayer dollars destroyer of real estate wealth. Banks had fire sales on REO in fear that they would be killed by the RTC. That in turn lowered market values putting more borrowers upside down on their mortgages increasing incentives to walk away etc. I could go on, but just know a similar agency for distressed loans and derivatives is a bad idea that would make things worse.

Lowering interest rates IS the right idea. It makes all cash flow instruments more valuable. There is a price/rate for nearly every instrument. Even bonds for bankrupt companies with no chance of recovery have traded at a price, similar their stock, albeit for pennies on the dollar. But just as a lower rate makes a fix rate bond more valuable, so it makes any cash flow instrument more valuable even if it's thirty five cents instead of thirty cents to the dollar. Since liquidity, like everything else, is at the margin, all markets related to the FFR will become more liquid at the margin. I'm sure you'll agree that any increase in liquidity has a multiplier effect, just like any decrease has a negative multiplier effect. So, a decreases in rates can help turn this ship around.

And how can it help real estate? Since many ARMs are tied to rates that relate in some way to the FFR, a decrease in the FFR within a few months directly reduces mortgage expense for at least a third of those with mortgages. It's like money for nothing and these lower mortgage costs not only drove up housing prices but increased disposable income for millions. This is why I have been cursing Bernanke's miserly rate reductions of the past six months. If he had knocked a percent off in August and another one in September we would still have problems but we wouldn't be skidding over cliff. Let's just pray he doesn't think he's done enough.

[Ezzyme]

Dear Alan,

Please stick to picking stocks and calling markets. I'm in awe of your recent calls.

The RTC was a disaster. One of the biggest waists of taxpayer dollars destroyer of real estate wealth. Banks had fire sales on REO in fear that they would be killed by the RTC. That in turn lowered market values putting more borrowers upside down on their mortgages increasing incentives to walk away etc. I could go on, but just know a similar agency for distressed loans and derivatives is a bad idea that would make things worse.

Lowering interest rates IS the right idea. It makes all cash flow instruments more valuable. There is a price/rate for nearly every instrument. Even bonds for bankrupt companies with no chance of recovery have traded at a price, similar their stock, albeit for pennies on the dollar. But just as a lower rate makes a fix rate bond more valuable, so it makes any cash flow instrument more valuable even if it's thirty five cents instead of thirty cents to the dollar. Since liquidity, like everything else, is at the margin, all markets related to the FFR will become more liquid at the margin. I'm sure you'll agree that any increase in liquidity has a multiplier effect, just like any decrease has a negative multiplier effect. So, a decreases in rates can help turn this ship around.

And how can it help real estate? Since many ARMs are tied to rates that relate in some way to the FFR, a decrease in the FFR within a few months directly reduces mortgage expense for at least a third of those with mortgages. It's like money for nothing and lower mortgage costs not only drove up housing prices but increased disposable income for millions earlier this decade. Lower payments will make it easier for the marginal home owner to stay out of foreclsure reducing foreclosures reducing the downward spiral effect. This is why I have been cursing Bernanke's miserly rate reductions of the past six months. If he had knocked a percent off in August and another one in October we would still have problems but we wouldn't be skidding over a cliff. Let's just pray he doesn't think he's done enough.

[AlanBrochstein]

Thanks for your thoughtful response. I understand your point, but I disagree about the lower rates. The issue is that there is a lot of paper out there "on margin". What is the rate that people who are facing capital calls/margin calls are enticed to take more risk? THERE IS NO RATE IF THEY ARE OUT OF CAPITAL. I spoke to a reporter yesterday and asked her if she would borrow money from me at zero percent to invest in something whose principal value could go to zero. Of course, she immediately and correctly said no. So, while lower interest rates do help some, they don't address the black hole problem in my opinion. The interest rate effect on ARMS is helpful to some degree, but it doesn't address the problem that in many markets home prices are way above the level that would be consistent with incomes. I guess some people will be tricked (again) into paying a higher-than-rational price due to the availability of "cheap money", but we are only prolonging the inevitable. What I am trying to address in this article is a way to truly restore confidence to the financial system. I am afraid that we need government guarantees (maybe not capital, just promises to back-stop). Finally, do not underestimate the potential for very low rates to alienate foreign central banks. We wouldn't want them to dump our bonds, would we?