Black Tie
Wealth Management
1
|
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Jaime
Cuevas Dermody |
Financial Crisis, Deleveraging, Hyperinflation & Policy
The Financial Crisis: why, where it is going & how to fix itJaime Cuevas Dermody,
Financial Engineering LLC, 1855 Lake Drive,
Delray Beach, FL 33444 561 278-4100
jaime@fe.net
(0.) PREAMBLE
This paper was originally prepared for a
talk on “The Dangers of Printing Too Much Money”.
It was given on 17 June 2008 to the
Investment Management Institute Conference at the
Avenue Hotel in Chicago. In that talk, I
said that every major Wall Street investment bank
was bankrupt, or in grave danger of it, for
the reasons given in Subsection (2.3) below.
Many in the audience since apologized for
ridiculing that remark and suggested making the
talk into a paper updated for recent events.
In doing so, I have focused on the legal and
regulatory environment that precipitated the
financial crisis, the “market failure” in the
CDO (collateralized debt obligation) market
that sparked the crisis, its spread into a general
credit crisis, the consequences of the bail
out of financial institution, and Government actions
that can alleviate the crisis.
Section 1 is a history of the current
financial crisis, in particular its regulatory, legal, and
policy foundation. Sections (2.) and (3.)
explain the mechanics of how the CDO crisis began
and spread to a general financial crisis.
Section (4.) points out important side effects of the
crisis, including home-collateral
destruction and the bailout inducing greater risk taking at
rescued firms. Section (5.) discusses the
reduction in loans outstanding from money-center
banks (deleveraging).
Section (6.) makes 10 recommendations for Government Action.
First, is 9 specific policy actions. Second,
is one recommendation on the announcement of
the first nine actions, in order to obtain
an effective psychological impact on the markets.
The latter is as crucial as the former,
because it must restore both investor confidence in
those institutions and consumer confidence
in continued employment. Without that confidence,
the economy will not recover. Sections (7.)
and (8.) discuss the short-term and longterm
consequences, respectively, of the current
Government bail outs, and in particular of
two polar cases of financing it. This
analysis suggests we will face 10% to 20% short-term
Libor rates one to three years from now.
Section (9.) is a brief conclusion, that warns that
the recommended actions are needed before
investors and consumers are further panicked
by the specter of massive retail-store
closings and home-collateral deterioration, which is
likely to worsen in the first and second
halves, respectively, of 2009.
(1.) WHY
(1.1) Regulatory and Legal Precursors of the
Crisis
Bad regulatory and legal changes occurred in
the 1970s and 1980s. Milestones include:
1975 Securities and Exchange Commission
(“SEC”) Rule 15c3-1 uses the ratings of
“nationally recognized statistical rating
organizations”1
(“NRSRO”)
for broker-dealer
net capital requirements. Over the next
decade, “The
SEC and other regulators
effectively ceded to CROs their public-interest
responsibilities for monitoring and disclosing
investor loss exposure in structured
financial instruments.”.2
1
The SEC designated
credit rating organizations (“CROs”) as NRSRO through
‘no-action” letters in response to requests
by security issuers. In 2006, The Credit
Rating Agency Reform Act (PL 109-291) required the SEC to
set up a formal
process for NRSRO designation but not
regulation. In 2007 the SEC did that.
2
Caprio, G. Jr.
(Williams College), Demirguc-Kunt, A. (World Bank), and
Kane, E.J. (Boston College & NBER). “The
2007 Meltdown in Structured Securitization:
....”. Working Paper. 5 September 2008. CRO means credit
rating organization,
which includes the NRSROs.
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1982 SEC begins requiring less disclosure3
for
issuance of securities rated in the highest
four rating categories of at least one
NRSRO, e.g., at least BBB from Standard &
Poors (“S&P:) or Baa3 from Moody’s Investor
Service (“Moodys”). It also shielded the
NRSROs from liability.4
In 1992 it
amends Rule 3a-7 to exempt from registration
asset-backed securities that are in such
categories (57 FR 56256, Nov. 27, 1992).
1984 The Secondary Mortgage Market
Enhancement Act (Public Law 98-440) eases issuance
requirements of asset-backed securities that
are a “mortgage related security”,
which it defines as one in the highest two
rating categories of at least one NRSRO
(e.g., at least Standard and Poors AA or
Moody’s Aa3).
1987 Federal Reserve Bank (“Fed”) expanded
its use of NRCRO ratings beyond requirements
for bank-portfolio (of marketable
securities) to prudential rules of bank supervision.
5
It defined “externally
rated” in Code of Federal Regulations Title 12 Part 325
Subpart B Appendix A (6.). That year, its
Regulation T set the above-mentioned
highest two categories as the standard for
margin lending on securities.
1988 The international Basel I Accord is
established with simplistic risk-weight ing of assets
classes, and the major commercial banks
react by: arbitraging this weighting to
leverage their capital, and seeking the most
profitable regulatory home around the
world for each aspect of their operations.
1988 The first structured investment vehicle
(“SIV”) is created by Citibank to take advantage
of the above, and dozens of other SIVs
follow. SIVs issued short-term commercial
paper and mid-term notes to fund the
purchase of much-longer-maturity CDOs,
all off balance sheet. Some SIVs were funded
instead by issuing tranches of their
CDOs. Many hedge funds leveraged purchases
of CDO with lines of credit.
1989 Department of Labor issues Prohibited
Transaction Exemption 89-88 (54 FR 42582,
17 October 1989) to ERISA, that allows
pension funds to invest in asset-backed securities
rated in the above-mentioned highest two
categories.
Financial Institutions Reform, Recovery and
Enforcement Act of 1989 bans thrifts
from buying bonds that are not in the
above-mentioned highest four categories (PL
101-73 103 Stat.183, 12 U.S.C. 3331-3351, 9
August 1989).
1991 SEC amends Rule 2a-7 to require money
market funds to hold 95%, instead of 0%, of
assets in the highest short-term rating
category of a NRSRO or in unrated assets of
comparable quality. For S&P it is A-1 and
for Moody’s it is P-1. See Investment
Company Act Release No. 18005, 56 FR 8113,
27 February 1991.
2000 Department of Housing and Urban
Development issued regulations for Freddie Mac
and Fannie Mae, that significantly raised
goals (with penalties for not reaching them)
on their purchase of residential mortgage to
low-income households from 2001 to
2004. No one seems to have dissented.6
These and similar events are explained in
detail in the three insightful articles cited in footnotes
2, 5, and 11.
3
SEC Securities Act
Release No. 33-6383, 47 FR 11466, 16 March 1982.
4
Rule 436 {47 FR
1141, as amended 58 FR 62030, 23 November 1993] deems NRSRO
ratings in a prospectus as not part
of that prospectus for purpose of Section 7
and 11 of the Securities and Exchange Act, thus shielding
NRSROs from expertwitness
liability and the negligent standard of
care.
5
Cantor, R. and
Packer, F. “The Credit Rating Industry” Federal Reserve Bank
of New York Quarterly Review, summerfall
1994.
6
HUD’s Reglations of
Fannie Mae and Freddie Mac: Final Rule, 31 October 2000, 65
FR 65044-65229.
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(1.2) House Price Bubble: February 1997 to
July 2006
The housing and credit bubbles, that
precipitated the financial crisis, was a perfect storm
born in the confluence of:
(a.) Commercial and investment banks' and
mortgage originator’s well-developed and ingenious
exploitation of those unfortunate
milestones,
(b.) NRSRO’s manipulation of their rating
standards and mathematical models to maximize
fees for both advising security issuers and
rating their issues,
(c.) Expansion of land use restrictions
(that have been growing in area like Providence RI,
Boston MA, Monmouth NJ, Philadelphia,
Seattle WA, and San Francisco since 1970)
accounted for about 20% of the house price
rise from 1987 to 2006.7
Construction
costs from 2000 to 2008 have risen an
average of 4.8%/year compounded.8
(d.) A general and steep fall in interest
rates from late 2000 to mid 2004,9
(e.) Rising incomes in a robust economy
(except for March to November 2001),
(f.) Maturing of economically more-efficient
financial conduits between ultimate lender
and ultimate borrower,
(g.) 2007 change in US tax law and in
accounting standards, and
(h.) Almost completely ineffective Fed, SEC,
OHFEO, FDIC, and FINRA oversight.10
Millions of people, for the first time in
their lives, qualified for home mortgages, and most
others could quality for much larger
mortgages and more credit in general than was previously
possible. Investment and commercial banks
sought all manner of loans to securitize
and market as a CDO, as long as most of that
CDO could be highly rated by an NRCRO.
They did this to maximize fees and minimize
both their capital engaged and liability for bad
loans, under their windfall of regulatory
changes and oversight. NRCROs developed evermore
clever statistical arguments to justify AAA
and AA ratings for ever-larger parts of CDO
cash streams, including CDOs backed by
subprime loans. Before securitization, originators
carefully scrutinized loans because they
usually kept them and lived with the consequences
of any defaults, all under the direct
scrutiny of bank regulators. Now the bank regulators
and the SEC entrusted the regulatory keys to
the NRCROs, who used them to make record
profits in parallel with the originators,
and the securitizers (who usually were commercial
and investment banks), and the marketers who
sold the securitized bonds.
In particular, home mortgages were pooled
into mortgage-backed securities (MBS), that
were repackaged into CMOs (collateralized
mortgage obligations). A CMO is a set of bonds
that are each the rights to a part of the
entire MBS cash stream. It is one of many types of
7
See the second
paragraph of Section 5 of this remarkable article. Eisher,
Theo S. “House Prices and Land Use Regulations:
A Study of 250 Major US Cities”. Working
Paper Version 2 May 2008. Forthcoming
Northwest
Journal of Business
and Economics.
http://depts.washington.edu/teclass/landuse/
8
The Turner Building
Cost Index measure the cost of building construction in the
US (excluding land). This index is computed
by the Turner Construction Company from
labor rates and productivity, material prices, and the
competitive condition
of the marketplace nationwide. It is widely
used by the construction industry and by Federal and State
governments.
The Turner Construction Company is one of
the largest construction management firms in the world.
9
Many adjustable-rate
mortgages were indexed on 1-month Libor, which fell from
6.827% in November 2000 to 1.007%
in April 2004, rose to 5.4975% in August
2007 and fell to 1.621 in November 2008.
10
Last four are:
Office of Federal Housing Enterprise Oversight (independent
regulator of Freddie Mac and Fannie Mae
from inside HUD), Federal Deposit Insurance
Corporation, and Financial Industry Regulatory Authority
(Non-government
organization formed from oversight
departments of NASD and NYSE in 2007. The latter regulates
their members and broker-
dealers and those of most US stock
exchanges).
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CDO. The resulting surge of easy credit
fueled effective demand for consumer durables and
houses that: raised house prices 86.4% from
November 2000 to July 2006 (64.2% adjusted
for inflation); caused an increased in home
and consumer durable production, and thus
raised GDP (gross domestic product = value
of all goods and services produced in the US).
This house price rise had several pernicious
effects. It embolden home borrowers, lenders,
securitizers, and CDO salespeople. In
particular, it lead amateur speculators (“flippers”), to
borrow more often and larger, which bid up
house prices still further, and worst of all, both
masked and rewarded rushed, careless, and
occasionally fraudulent lending. Some of these
mortgages were home-equity lines that
further fueled the surge in consumer-durables.
Such careless practices were epitomized by:
three investment banks, namely Bear Stearns,
Lehman Brothers, and Merrill Lynch, as well
as, a prominent home-mortgage originator,
New Century Financial Corp. (formerly NYSE
NEW, now Pink-sheet NEWXQ). The 2007
Fortune Magazine Corporate Rankings for
these firms were 138, 47, 22, and 700, respectively.
On 1 January 2007, New Century was the
second-largest US subprime homemortgage
originator, with 7,200 full-time staff and a
$1.75 billion market capitalization. It
filed for bankruptcy on 2 April 2007. On 16
March 2008, Bear Sterns and JP Morgan announced
a merger, that saved the latter from
bankruptcy. On 15 September 2008, Lehman
Brothers filed for bankruptcy, and Bank of
America announced it would acquire of Merrill
Lynch, which saved the latter from
bankruptcy. The Fed and Treasury accommodated and
subsidized the merger and the acquisition.
In this late-2000-to-early-2007 heyday of
securitization, the major commercial and investment
banks continually improved their regulatory
arbitrage. They devised ever-more efficient
ways of minimizing the capital used and
maximizing the fees earned. This was possible
because of the ever-growing demand for
highly-rated CDOs, that in turn was fueled by
the regulatory and legal changes, like
milestones (i.) through (iv.) above. Caprio
et al
point
out the SEC’s and Fed’s role in creating
this demand: “On the demand side, the SEC and
bank regulators set rules that fed a huge
demand, by trusteed investors, for investment
grade and other highly-rated debt.”1
These banks
partnered with vast networks of sales
forces that originated loans and others that
placed the securitized bonds. These securitizations
were done nominally off their balance sheets
(under Basil I) in league with NRCROs,
which had strong profit incentives to
overrate securitizations. The entire process proceeded
under the blessing of, but with little or no
scrutiny from, the SEC and bank regulators. The
leverage, risk, and complexity of the
securities those banks sold and held rose dramatically.
All this is chronicled in two recent papers,
which provide good explanations of the regulatory,
legal, and policy origins of the financial
crisis.1,11
Hence, CDO volumes soared and their true
average quality plummeted. In 2001 $330 billion
of new subprime, Alt-A, and home-equity-line
residential mortgages were issued, which
was 15% of all new mortgages on US
residences. In 2004, it grew to $1.1 trillion and 37%,
and peaked in 2006 at $1.4 trillion and 48%.12
From 1995
to 2005, mortgage-backed security
(MBS) pools, that were collateralized by
subprime home mortgages (excludes Alt-A and
equity line), grew from $18.5 to $507.9
billion.13
The S&P
Case/Shiller 10-city Composite
Index was 75.43 at the start of the bubble
in February 1997 and peaked in June 2006 at
226.29. This was a 12.61%/year compound
increase. Inflation averaged about
2.21%/year compounded in that period. Hence,
house prices (adjusted for inflation) rose
11
A Congressional
Research Service Report for Congress by Getter, D. E.,
Jickling, M., Labonte, M., and Murphy, E.V.
“Financial Crisis? The Liquidity Crunch of
August 2007”, 21 September 2007. Order Code RL34182.
12
Inside Mortgage
Finance, 2007 Mortgage Statistical Annual, vol. 1, p. 3.
13
These MBS are used
to create mortgage-backed bond, pass-through securities,
CMOs, real estate mortgage investment
conduits, and stripped MBS. See footnote 2.
CMO stands for collateralized mortgage obligation, which is
the set bonds
that are the rights to the cash stream from
MBS.
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10.31%/year on average in the bubble.14
(1.3) House Price Bubble Burst
The US house bubble peaked in July 2006 and
home prices fell nationwide 21.77% by September
2008.15
So many
home-mortgages defaulted by March 2007 that the (often
circuitous)
pass-through payments to CMO and CDO holders
fell notably. The first prominent
CDO failures started with 90% and 100%
deficiencies, respectively, in monthly cash flow to
two Bear Stearns hedge funds16.
These funds held leveraged subprime CDO positions, and
in June 2007 began to close.
This spread panic into the rest of the CDO
market in less than a month, other credit markets
worldwide, and all the other financial
markets by September 2008. Investor panic depressed
many asset prices to irrational levels, and
mark-to-market accounting rules17
then
forced hedge funds and investment-bank
proprietary traders to show losses, even on assets
with steady cash flows, good collateral, and
miniscule defaults. That led investors to withdraw
equity and loans to such funds and traders,
and in some cases led counterparties to
stop trading with them. Hence, the very
people who could bring price discovery and rationality
to the market were sidelined. Their absence
unbridled the irrational fall in prices and
thus exacerbated investor panic. Eventually
the investors holding the MBS and CDOs, who
foolishly trusted the regulators and their
proxies, the NRCROs, lost far more money than
the NRCRO, originators, and bankers made,
and created the current financial crisis.
The financial crisis is having several
negative side effects, that will in turn, exacerbate the
crisis. The most important of these is the
destruction of mortgage collateral value. We are
facing a repeat of the home-collateral loss
from the 1980’s saving & loan crisis, on a vastly
larger scale, as explain in Section (4.)
below. Another effect is that the Government owing
almost 80% of firms like AIG has made the
management much less risk averse. Since receiving
a $150 billion bailout they are risking
mostly the Government’s money. AIG is now
taking enormous risk by selling commercial
insurance at half the price of their competitors.
The essence of the financial crisis is the
lack of investor confidence and trust in financial
institutions and the information they
provide. These institutions include fund managers,
investment advisors, legal and accountant
firms, rating agencies, credit-enhancement providers,
commercial and investment banks, as well as,
Government regulators and officials.
The panicked-investment climate led
investors to shun assets not guaranteed by governments,
and employees to lose confidence in their
future employment. The former sent the
prices of such non-guaranteed assets
plummeting, and the latter triggered a fall in consumption.
Thus, businesses have had difficulty in both
financing their production and in
selling it. These two behaviors feed on each
other and started the recent spiral of lower asset
prices, output, employment, and store
closings.
(2.) THE SPARK: “MARKET FAILURE” IN CDOs
Market failure is the economic condition
defined by a free market not achieving efficient al-
14
We use the S&P
Case/Shiller Index Compoiste 10-City Index CSXR because the
OFHEO index has probems and the
20-city index was not computed before 2000.
15
June 2006 to
September 2008 Composite 20 values of the S&P/Case-Shiller
Home Price Index.
16
Two Cayman Island
funds: Bear Stearns High-Grade Structure Credit Strategies
Master Fund Ltd. and Bear Stearns
High-Grade Structure Credit Strategies
Enhanced Leverage Master Fund Ltd.
17
Rules that require
assets to be valued (‘marked”) on balance sheets (daily in
many cases) at the price at which it is
traded, or in the absence of an observable
price, at a theoretical equivalent value. Each such price
change is an income
event.
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location of scarce resources. This efficient
allocation is known to economists as a “Paretooptimal
allocation”, and is defined as an allocation
for which no reallocation can make any
market participant better off without making
another worse off. It is equivalent to achieving
a price equilibrium, in which everyone is
holding the set of assets they want, given the market
prices and their budget constraint.
Theoretically, in such an allocation, investors who
are willing and able to pay the most for a
given asset, like a CDO, are left holding it.
This definition of market failure is vague.
Some economists and commentators describe a
market as suffering from market failure,
when in fact that market merely has significant
transaction costs that are overlooked and
cause suboptimal allocation. The current markets
for CDOs, and Level III assets in general,
suffer from three important transaction costs
that, in part, explain the lack of trading
and therefore of apparent market failure. I will label
these types of transaction costs: asset
complexity, valuation complexity, and propertyright
complexity. These transaction costs are
explained in Subsection (2.1) and their effects
on the financial markets are described in
Subsection (2.2) and Section (3.) below.
(2.1) TRANSACTION COSTS
While these explanation of transaction costs
may seem tedious, they are crucial for grasping
the mechanics of the market failure that
started the financial crisis. To understand the effects
of these transaction costs on those markets,
let us start from the simple and obvious
premise that any particular asset is valued
by an investor based on his or her expectations
of that asset’s future cash stream.
(2.1.1) Asset-Complexity Transaction Cost
Many of these debt instruments, like CDOs,
have complex cash flows by their very nature.
A CDO is the right to the repayments of
thousands of loans (that last up to 30 years), net of
the collection costs (e.g. the servicing of
the performing loans and the workout, collateral
foreclosure and/or maintenance costs of
nonperforming loans). The most complex type of
CDO is a collateralized mortgage obligation
(“CMO”), which is a set of bonds that are the
rights to various parts of a mortgage backed
security (“MBS”). An MBS is a pool of home
mortgages, each of which allows the borrower
to prepay any part or all of the mortgage
without penalty.18
To value a CDO cash stream, one must form a
probability distribution over the future behavior
of thousands of borrowers, whose loans are
part of a single CDO. This behavior is
affected by several primary factors,
including collateral values and borrowers’ ability and
willingness to make their payments. These
primary factors, in turn, depend on future
changes in secondary factors: (a.)
employment rates and geography, (b.) interest rates,
(c.) replacement costs of collateral, and
(d.) taxes. These factors change both the CDO cash
streams, via their relation to the
propensity for prepayment and default, as well as, the
economic
impact of such on the CDO holders, e.g., the
reinvestment rate for prepaid principal.
For CMOs, add the contagious loss in
collateral value from home abandonment. This creates
intricate feedback loops that are difficult
to predict.
The models used to value CDOs, backed by
home MBS, assumed that delinquent home
loans would be well managed for the benefit
of CMO holders. This involved workout or orderly
foreclosure and resale of the homes. But the
sheer volume of delinquent home mortgages
since 2006 has overwhelmed the ability of
bankers and mortgage servicers to cope.
This has greatly reduced collateral value
and lead to a contagion of foreclosures. In general,
bankers and servicers are not able to
efficiently deal with the delinquencies and collateral.
18
This right is an
American call option (which the lender in effect sold the
borrower) on the mortgage, that is embedded in
the mortgage and paid for with a higher
interest rate than would otherwise be the case.
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The highly-heterogeneous nature of CDOs is
another part of this complexity. Just in the
CMO variant of CDOs, there are many basic
types of home loans, often in the same CMO:
fixed rate, floating rate, hybrid (part
fixed and float), low “teaser” fixed rate turning to higher
fixed or floating rate, non-amortizing
balloon payment loans, graduated payment, negative
amortizing, “no documentation”, and
“no-income verification”. This heterogeneity continues
with the different homes that are mortgaged
and the particular circumstances of those
mortgages, including quality of the
documentation involved, local real-estate markets, the
income and economic circumstances of the
borrower, and state laws, etc. This complexity
is sometimes exacerbated by the partition of
the CMO into many different bonds. Some of
this partitioning creates additional risk,
as in principal-only and interest-only bonds. When
part or all of a CMO is paid off early, any
principal-only bond holder is helped by earlier repayment
of principal, undiminished for the time
value of money, whereas the interest-only
bond holder is hurt by losing their payments
for that part of the loan.
Hence, it is difficult for CDO investors to
understand both the mechanics of the promised
cash stream and a probability distribution
over that stream. I recently reviewed a 15-page
bid on valuing the bonds from a CMO. The bid
was $240,000 to construct a model of the
cash flow, and $64,000/month to maintain it.
All of this increases the risk and cost of
trading CDOs, to an even greater degree than
the heterogeneity of the municipal and corporate
bonds does in those markets. It also makes
investors more leery of coping with CDOs
when their value changes in unexpected ways,
because it is so difficult to appreciate their
circumstances or to evaluate alternative
strategies, e.g., holding, selling, or hedging.
(2.1.2) Valuation−Complexity
Transaction Cost
A fundamental task of accounting is to
assign a useful value to an asset. In November
2007, the Financial Accounting Standards
Board’s issued Statement of Financial Accounting
Standard (SFAS) 157. It required many firms
to mark to market financial assets. The
lack of a liquid CDO market has made this
difficult and led to a disparity of values among
holders of the same instrument. The
theoretical foundation of SFAS 157 is problematic.
The value of an asset to a firm depends in
part on how it intends, and how it is able, to
make use of that asset. In many cases, a
firm intends to sell the asset and cannot make
economic use of it in any other way.
Consider a medical supply firm owning an X-ray machine,
with no ability to use it for anything but
selling it. In contrast, a radiologist can use
it either as a diagnostic tool, and thus
earn a stream of marginal revenue from it, or sell it.
Suppose the medical supply house can
profitably sell it for $10,000 with $1,000 of additional
marketing costs, and the radiologist can use
it to increase the present value of his or
her cash flow by $20,000. Further suppose
there is a tax credit on the machine for doctors,
but not suppliers, worth $1,000 in present
value. Then the machine’s economic value to
the supply company is $9,000, but to the
radiologist it is $21,000.
Real estate workers often use an analogous
concept of “highest and best use” to describe
the particular use of a property in valuing
it. Note that these two values above do not violate
the economic “law of one price”, but rather
explain why the medical supply company is
happy to sell a machine, and the radiologist
is happy to buy it, for a $10,000 price. Some
firms can never use an advantage associated
with an asset, while others can. Such advantages
include economies of scale or scope,
marketing, technology edge, and regulatory or
tax advantages. Thus, the net value of an
asset and its associated tax credit differ across
firms, and this often explains why some
firms will sell it to others. In Section (6.) below,
changes to FASB 157 are suggested that will
more closely reflect economic reality and will
eliminate the accounting-driven part of the
financial crisis.
(2.1.3) Property–Right Complexity
Transaction Cost
There are a variety of state “anti
deficiency” laws regarding borrowers’ obligations when the
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loan balance of repossessed home exceeds the
home’s liquidation value. They were first introduced
during the Great Depression. For example, in
California [CCP 580(b)], New York
[RPAPL 1371], Arizona [ARS 33-729(A) and
33-814(G)], and North Dakota [32-19, 1-07],
borrowers are not liable for more than the
collateral of a principal residence. In California,
this applies even if the owner has converted
his or her home to a rental unit. Borrowers in
such states have an incentive to surrender
their (house) collateral in complete satisfaction
(“SCICS”)
of the loan, if they can buy an identical house across the
street for substantially
less than their home-loan balance, or rent
such a house at a rate that reflects this lower
value. But there was a strong tax impediment
to this incentive, and that impediment supported
the value of CMOs. SCICS implied immediate
(“forgiveness-of-debt”) ordinary income
equal to any loan balance in excess of the
home-collateral liquidation. A borrower who
chose SCICS incurred federal income tax on
such excess.
As stated in Section (2.), US housing prices
declined 23.41% from their peak in July 2006
to October 2008 (latest available).14
The
greatest declines were in the Phoenix, Las Vegas,
Miami, San Diego, San Francisco, Los
Angeles, Tampa, and Detroit areas, which had
40.55%, 39.15%, 37.69%, 36.11%, 35.93%,
34.34%, 30.51%, and 30.14% declines, respectively,
in that period. Thus many borrowers in some
states have had an incentive to SCICS,
which used to be retarded by the federal
taxes mentioned in the previous paragraph. However,
in December 2007 Congress passed the
Mortgage Forgiveness Debt Relief Act of 2007,
which waived such tax on principal
residences. This removed the impediment, thus increasing
SCICS and reducing the value of CMO cash
streams.
Investors must now construct more subtle
probability distributions over collateral surrender,
for that part of the (often thousands) of
home mortgages in a given MBS or CMO which
are in states allowing SCICS. Current home
owners who can use SCICS benefit. Bond
holders lose, including the average citizen
who has a pension or insurance policy that owns
such MBS or CMOs. Their retirement income
will be reduced. Anyone who will apply for a
home mortgage in the future will lose, in
the form of higher interest rates stemming from
the added risk of SCICS unbridled by taxes.
To the limited extent that this transaction cost
feeds the above-mentioned “market failure”,
it makes every citizen poorer and less secure.
One sign of this cost to home owners is the
refusal of some investors to buy MBS or CMOs
that include California home mortgages.
(2.2) IMPACT OF TRANSACTION COSTS ON CDO
MARKETS
The complexity, accounting, and
property-rights transaction costs above have had a
particularly
detrimental effect on the CDO market. Many
of these instruments are held by institutions
and investors who lack the mathematical
expertise to model their cash flows. In
particular, the original models used to
price new MBS and CMOs before June 2006
(whether those of the investor or the
investment banker selling them) had particular probability
distributions over home prices, and assumed
an economic environment with the tax
impediment described in Subsubsection
(1.1.3) above. First, the realization of those home
prices turned out to be in the lower few
percentiles of the probability distributions used,
and many CDOs, not associated with home
loans, suffered defaults in the top few percentile
of the probability distributions used to
model them. Second, the tax-impediment to SCICS
for loans associated with MBS and CMOs
vanished in 2007, which greatly increased SCICS
in those states that allow it.
Current and potential CDO investors lost
faith in the models, and have even less faith in
the more-complex models now required to
treat SCICS. They want out of their CDO positions.
The huge number of such CDO holders has
created an overhang of supply in the
market, which leads even
mathematically-sophisticated and well-capitalized investors
to
fear that whatever the current price is, it
will go lower.
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This fear is accentuated by the recent
experience of exactly such investors. Last year, many
of them correctly determined that some
high-quality CDOs were selling for less than the
present value of any realistic probability
distribution of their future cash flows. They purchased
such CDOs, often with leverage. As the
events described above unfolded, CDO
prices fell still further below any rational
valuation, even given those events. Most of these
sophisticated investors are hedge funds or
proprietary desks that must mark their CDOs to
market. Thus, they have been showing their
investors or parent organizations serious
losses, which together with the lack of
liquidity, have cut off their access to equity capital
and borrowing. This despite the fact that
the cash flow of these marked-down CDOs, from
purchase to maturity, is very profitable.
Hence the very market participants who might
bring price discovery and liquidity to the
market (and make a profit in the process), and
thus Pareto efficiency, are out of the game.
This explains the lack of a market in CDOs and
what passes for “market failure”.
The spread of the financial crisis from
markets for assets that were previous overvalued to
the markets for assets that have good cash
flows, is in large part a mark-to-market accounting
problem. Suggestion (E.) in Section (6.)
would attenuate this problem, by allowing
firms to value assets on a present value
basis. Note that insurance companies have a very
different regulatory regime, that does not
use FASB 157, and as a consequence, they have
been largely spared the financial panic of
many other finial institutions. The problems with
AIG stemmed from their London subsidiary,
which was not under US insurance regulation.
(2.3) LEVEL III ASSETS
The problems described above are
crystallized in the Level III assets held by major financial
institutions. CDOs are now Level III assets.
Level I assets are those assets for which there
is a liquid-market price available. Level II
assets are those assets that can be valued by a
close proxy asset and a no-arbitrage
argument. Level III assets are those assets for which
neither of these is available. The latter
require complex mathematical models and many assumptions.
At best, hedge-fund managers and the traders
on proprietary trading desks, that own these
assets, have good insight into their true
value. But internal and external auditors, risk
managers, rating agencies, and regulators
are far less knowledgeable about their worth.
Many Level III assets have been grossly
over-rated by rating agencies. As if that were not
bad enough, those same managers or traders,
that are responsible for marking their Level
III assets to market, are paid fees or
bonuses based on how much those marks rise each
year. Thus, many Level III assets have been
marked far above any reasonable measure of
their worth. The CDO market failure
immediately focused investors on these problems,
making them undesirable, and thus virtually
stopped trading in Level III assets.
Many of the major investment banks and other
financial institutions, with substantial Level
III assets and high leverage, have
overvalued Level III assets. This has occurred to such an
extent that they were bankrupt, or could
have quickly become so. They may own CDOs directly
and/or have exposure to them via
credit-default swaps. Note that mathematical
complexity masks reality enough so that many
of these obligations were grossly overvalued
by such proprietary desks, while other firms
have recently marked the same assets at values
far below a rational present value of their
cash flows. Sheer uncertainty is added to the
already-scary credit markets by firms
unpredictable adjustments to Level III values.
Examples of the July 2008 ratios of Level
III assets to equity are reported by The Financial
Times website FT.com ($s in billions):
Citigroup ratio 1.05 = $135/$128; Goldman Sachs
ratio 1.85 = $72/$39; Morgan Stanley ratio
2.51 = $88/$35; Bear Stearns ratio 1.54 =
$20/$13 billion; and Merrill Lynch ratio
0.38 = $16/$42. Even if the illiquidity and overvaluation
of these assets has not made them bankrupt,
they are in danger of spiraling to
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such a state in a few days if suspicions
develop that their Level III are substantially overvalued,
because they will not be able to trade.
Counterparty will not trade with them if: (i.) it
is widely feared their assets may be marked
down far further, or (ii.) if it is widely believed
that any of several credit-worthiness
measures drop below contractually-specified levels (a
“credit event”) in any of their hundreds of
bilateral ISDA (International Swap Dealers Association)
agreements. These measures involve
mark-to-market values and various financial
ratios. Worse yet, failing firms may default
or delay payment on some obligations to otherwise
solvent firms, leading to a cascade of
insolvencies.
(3.) SPILLOVER TO ALL FINANCIAL MARKETS
(3.1) SPILLOVER TO FINANCIAL INSTITUTION’S
BALANCE SHEETS
There is an enormous quantity of Level III
assets (including CDOs backed by US home
mortgages) widely held by the major
participants in the US credit markets. These participants
include the commercial and investment banks,
hedge funds, insurance companies,
and other financial institutions around the
world. Hence, the fall in Level III-asset prices
(where these prices can be found), the lack
of liquidity and price discovery, and the consequent
uncertainty have combined to impair the
balance sheets of these participants. This
has recently reduced the ability (at least
temporarily) of many prominent firms to act as
counterparties to trades in the general
credit markets.
Some of this risk of CDOs and other Level
III assets has been passed from one financial institution
to another via credit-default swaps (“CDS”).
The writers (issuers) of those CDSs
did not fully factor the transaction costs
described above into their valuations, and in general
grossly under-estimated the risks. This had
two pernicious effects. The first effect is
that it gave comfort to many investors
supplying capital to firms that purchased CDOs, because
much of the ultimate risk was insured, via
these CDSs, by firms with high credit ratings.
The most prolific issuer was London-based
AIG Financial Products, which is a subsidiary
of previously-AAA-rated AIG, that guaranteed
its obligations. The second effect is
that it spread potential insolvency to firms
that were not otherwise heavily involved in
CDOs, such as AIG and many of its
counterparties.
(3.2) BALANCE SHEET EFFECTS ON FALLING &
IRRATIONAL RELATIVE PRICES
The shock of such firms (like Bear Stearns,
Merrill Lynch, Lehman Brothers, Morgan Stanley,
AIG, and Goldman Sachs) suddenly being
unworthy to trade with in September 2008,
has contributed to a loss of investor faith
in many of the institutions and mechanisms of
the general credit markets. These investors
wonder who they can trade with safely and just
what they can count on after such a fall
from grace of the financial titans. They have been
fooled and disappointed by: investment banks
who sold CDOs, mathematical models that
valued such obligations, internal and
external accountants and rating agencies that determined
or opined on their valuations, as well as,
firms and funds that invested in such obligations.
This has stifled many normal commercial
activities of the credit markets, and
brought on the specter of bankruptcy or
Government bailout to many prominent firms.
A frightening consequence of this loss of
faith is its contagion from CDOs to almost all nongovernment
financial instruments: debt, equity, and
commodity. That has led to a write
down of the value of privately-issued
financial assets across the board, which has weakened
corporate and hedge-fund balance sheets, and
thus greatly impaired commerce. This will
be an economic disaster if it persists. The
switch of TARP policy in October 2008, from buying
illiquid fixed-income assets of financial
institutions to injecting capital into those institutions
via preferred stock purchases, recognized
this phenomena and its gravity.
US Treasury bonds are in great demand as the
other markets are becoming far less liquid
and investors are panicking. But even that
market is adversely affected by the panic, in
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that Treasury debt exhibited persistent
relative mispricing, and have Treasury prices have
risen irrationally. Hedge funds and
proprietary traders do not have sufficient capital and
borrowing capacity to arbitrage away such
mispricing. For example, on 30 October 2008,
nearly identical Treasury bond traded at
very different prices. In particular, on-the-run
(i.e., the newest) 10-Year Treasury bonds
yields were 40 basis points lower than yields of
such off-the-run (i.e., older than on the
run) bonds. At the same time, the 30-year Treasury
bond yield was 50 basis points higher than
the 30-year swap rate for 3-month Libor. This
suggests that Libor is expected to be safer
than Treasury debt. On 18 December 2008, the
Treasury reported that the average market
yield for 30-year Treasury bonds was 2.53%.
That yield is absurd in the face of the
likely inflation and higher interest rates in the next
decade, as its future cash stream will then
be discounted at a much high rate.
Such crazy relative pricing and absurdly low
yield are explained in part by traders being
forced out of positions for margin calls,
redemption, and/or reduction of credit lines, all
stemming in part from the distortions of
mark-to-market accounting. They held positions
that were very profitable arbitrages, if
they could have stay in them to benefit from the cash
flow. Unwinding those trades pushed prices
further out of line, making the arbitrage even
larger for anyone with the capital to hold
the positions. This is the key to spiraling down
and irrational relative-price levels, which
is hobbling the financial markets.
Many investors are not valuing assets
through the normal assessment of their probability
distribution of future cash flows, but
rather on how they think other investors will value assets.
It is as if each investor believes: “I am
rational, but I am choosing a strategy that is
optimal, given that the other investors are
panicked into irrational behavior”. This perceived
irrationality leads investors to shun assets
that are offered far under any rational
value on a discounted-cash-flow basis. Such
psychology is the heart of the financial crisis.
While the specific steps enumerated in this
paper to improve the credit markets are important,
none of them will help if this market
psychology persists. That suggests the announcement
and implementation of those steps, and/or
other such steps, is as important
as the steps themselves. The Government must
carefully craft and stage manage the presentation
of all its steps at one time, to impress and
dazzle the financial press and the markets
with the Government’s understanding of and
solution to the crisis. If the markets have
faith in the Government’s solution, then its
success will be a self-fulfilling prophecy.
The price drops across all classes of
assets, not guaranteed by the Government, have
greatly reduced the wealth of US consumers.
The famous “Pigou Effect” is the reduction in
consumption when people become less wealthy.
This reinforces such fall in asset prices as
private companies have less sales and
profits. As real output drops, in the face of the
commercial-credit shortage (reducing output)
and the Pigou Effect (reducing demand), there
are fewer good and services being chased by
the money supply. This will exacerbate the
high inflation that the bail out of the
financial crisis will eventually bring, as explained in
Subsection (6.3) below. If unchecked by
Government action, this mutually-reinforcing
combination, of businesses not being able to
finance output, consumers not buying output,
and asset prices falling, will culminate in
widespread retail-store closings, which will herald
a depression.
(4.) SIDE EFFECTS OF THE FINANCIAL CRISIS
There are several negative side effects of
the financial crisis and each in turn exacerbates
the crisis. One of the most important of
these is the destruction of home-mortgage collateral,
that supports the enormous volume of MBSs
and CMOs outstanding in the US. Another
is management of firms taking much greater
risks, because the Government took a
(just under 80%) equity stake in some in
some firms that they bailed out, like AIG. The
other side effects are less immediate. They
include massive commercial real-estate defaults,
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higher crime and drug-abuse rates, less
state and local spending on infrastructure, less
state and local, as well as, individual
spending on education. Each of these will retard economic
growth.
(4.1) HOME-COLLATERAL DESTRUCTION
A little-thought-about, but now-crucial,
consideration in the value of extant CDOs, backed
by home MBS, is the shortage of competent
personnel to assess and negotiate “work outs”
or to foreclose and resell collateral. In
the best case a delinquent home mortgage is:
(i.) modified so the borrower remains in and
maintains their home via mortgage modification
or exchanged for a rental agreement (in a
way that benefits both the homeowner
and CMO holder), or
(ii.) foreclosed and the home maintained and
resold for its market value in an orderly
manner, without damage, disrepair,
unnecessary ill effects on neighboring homes, or
interruption of insurance and property-tax
payments.
In the worst case, the absence of such
personnel has resulted in needless home abandonment,
which in turn has led to lower property
values and contagious abandonment of
neighboring homes. This has caused social
trauma for the home-owning families involved,
as well as, reduced the mortgage-collateral
value as homes fell into disrepair, were vandalized,
insurance and property taxes were unpaid,
and municipalities seized homes.
Most home-mortgage companies and servicers
appeared competent at originating, processing,
and servicing home loans when sales were
booming. However, they do not have the expertise,
staff, or organization to deal with workouts
and foreclosures at the current scale of
delinquencies. In general, such
organizations lack even the ability and inclination to
retain
and manage well-qualified contractors to
perform these services.
One frightening possibility in the next
three years is that part of the savings & loan crisis
will repeat. In particular, that there might
be massive: (a.) home-mortgage delinquency,
(b.) mortgage-originator failures, and (c.)
numbers of unemployed mortgage salespeople becoming
mortgage-delinquency managers attempting the
tasks in (i.) and (ii.) above. On average,
they would likely mirror the horrendous
performance of unemployed savings and
loan officers who became Resolution Trust
Corporation (RTC) officers.
From the 1989 establishment of the RTC until
all its assets were sold in 1995, 29.4%
($152.9 billion) of the $519.0 billion
value, in thrift assets acquired by the RTC, were lost.
This cost the Government $123.8 billion, and
cost the owners and creditors of 1,043 failed
thrift institutions $29.1 billion.19
That totals
$191.4 billion in July 2008 dollars. This loss
transpired in the very favorable housing and
business environment during which the RTS
operated (August 1989 to December 1995
inclusive). In that period the OFHE0’s repeatpurchase
House Price Index rose every quarter,
growing 27.04% in total and 3.90%/year on
average, while real output (adjusted for
inflation) grew 15.97%.20
This
contrasts with
much-less-favorable circumstance of the
current crisis, in which house prices fell 21.77%
since June 2006,21
and real
GDP fell at a rate of 0.5%/year in the third quarter of
2008.
Assume that only subprime, Alt-A, and
home-equity home mortgages currently outstanding
19
Weiss, N. Eric,
“Government Interventions in Financial Markets: ...”,
Congressional Research Service, 25 March 2008.
20
This is the Office
of Federal Housing Enterprise Oversight’s Repeat-Purchase
House Price Index. GDP rose every
quarter but one for a total 35.99% growth,
which is an compounded average of 5.04%/year. Real GDP
(i.e., GDP adjusted
for inflation) in that period rose every
quarter but two for a total 15.97% growth, which is a
compounded average of
2.36%/year.
21
We used the
S&P/Case-Shiller Home Price Index for this recent period
because it is widely regarded as a better measure
than the OFHEO Index, but could not use it
for the 1989 to 1995 because it did not exist then.
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default ever have any default. There are
about $6.5 trillion of such loans, compared to the
$0.649 trillion in assets acquired by the
RTC in 1989 in July 2008 dollars. That is 10
times as much assets and those assets have a
much higher delinquencies. The same proportion
of losses as the RTC suffered, with better
assets in a much better economic climate,
will leave us with $2.941 trillion in lost
collateral. That is more than 1/5 of the $14.5 trillion
of US GDP (20.3% of all the US goods and
services produced in 2008).
(4.2) RISK TAKING BY RESUCED FIRMS
The US Government now owns almost 80% of the
equity in some rescued firms, like AIG.
This has created a severe
incentive-compatibility problems between the management of
those firms and the Government as owner and
as watch dog of the country’s economic
health. The managers have little to loose
and much to gain by taking big risks, as their
share part of the profits but almost none of
the losses. Private stockholders, who would
otherwise police this behavior, are now
largely replaced by Government owners, who have
not the inclination, skills or incentive to
do such policing.
AIG in particular, has received a $150
billion Government bailout.22
Naturally, the
managers
of AIG are putting that to use to make as
much bonus and stock-option profit as possible,
without the usual oversight of private
stockholders. These managers do not share
much in the downside, and thus have a
powerful incentive to take big risks with that
money. After November 2008, AIG has been
booking a surge of commercial-insurance premium
by quoting much lower prices than their
competitors. Much of this business has
been at half the rate of competitors.23
The competition
has responded by lowering their
prices, so we getting systematically the
wrong incentives for risk taking by insurance buyers.
Sadly, many businesses are buying AIG
commercial insurance because the Government
now stands behind them, instead of shying
away from too-good-to-be-true prices that
would ordinarily make them wary of the
insurer’s ability to payout claims. It seems the
Government has leaned nothing from the
lessons of the bad policy milestones and developments
[enumerated (i.) thru (vii.) and (a.) thru
(f.) in Section (1.)], the perverse incentives
they created, and bad economic outcomes that
eventually resulted.
(5.) DELEVERAGING, WRITE−DOWNS,
AND DEFLATION
We have not addressed two recent effects on
the money supply:
(i.)
deleveraging of
US dollar
debt, i.e., reduction in US-dollar loans
outstanding, and
(ii.)
writing-down of
US bank
assets. Both phenomena are reported
worldwide, and if true, represent dangers to the US
economy, which offset temporarily the
inflation dangers of the bailout described in Subsection
(7. 3) below. Existing US-dollar loan
balances are reportedly being repaid faster than
the sum of: creation of new loans and the
net increase in existing loan principal. As mentioned
in Subsections (2.2) above, many financial
assets are being written down as their
market or perceived market value falls. In
this analysis, we will divide US dollar loans to
nonbanks into two classes: lending by
nonbanks and lending by banks.
Changes in balances lent by nonbanks do not
affect the US money supply as their issue
and repayment occurs by movement of money
between the demand deposits of lenders and
borrowers, thus not changing the total
demand deposits outstanding. However, changes in
bank lending does, according to classic
economic theory, effect the money supply, as borrowers
reduce their demand deposits to pay off
loans. A $1 reduction does not increase assets
of the bank, but rather frees up $0.10 of
their reserves, so that the bank can lend that
22
“AIG gets $150
billion government out; posts huge loss”. Reuters Business &
Finance Section 10 November 2008.
23
I obtained this data
from a few of the largest US commercial insurance brokers.
It can only be verified by comparing the
relative prices quoted of different
insurance carriers like AIG, and by comparing current quotes
with those made before
August 2008.
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$1 again. If the bank does not lend that
dollar, then the money supply is decreased (deflated)
by $1. That reduction is not increased by
the money multiplier.
As US banks write down the value of their
financial assets, their bank capital falls. However,
US banks must maintain 8% of assets in bank
capital, and these assets (in the language
of bank regulation) include demand deposits.
Bank capital is bank assets minus
bank liabilities. Thus, writing down an
asset in a bank’s capital by $1 theoretically reduces
the money supply by whatever reduction in
lending occurs, up to a maximum possible reduction
(for banks fully lent out with respect to
bank capital) of $1/0.08 = $12.50.
The factors in (i.) and (ii.) decrease the
maximum possible money supply, and thus in the
long run might offset money created for the
bailout. But, US banks are not fully lend out,
so the multiplier does not immediately come
to bear. Thus loans create money more than
vise versa.24
In any
case, the Fed Statistical Release H.3, H.6, and H.8 on 19
December
2008 shows each of measure of bank reserves
and money supply (net assets of commercial
banks, M1 and M2 money supply) rising over
the last three months and in comparison to
last year. Any deflation that might occur
from reduced bank lending will soon be swamped
by the inflation coming from the bailout as
explained at the end of Subsection (6.3) below.
(6.) RECCOMMENDED GOVERNMENT ACTION
Government action should accomplish two
tasks. First, it should immediately stop the general
market panic, and bring rationality and
price discovery to the financial markets. Second,
it should do so in a way that minimizes the
rise of inflation. However, the least possible
inflation in this situation will be high.
(6.1) Recommended Treasury Actions:
(A.) Purchase of preferred stock in US
money-center banks and the principal Treasury
dealers to bolster their balance sheets.
This will help restore counter-party
worthiness of major financial institutions, which is
a necessary, but not sufficient, condition
for the financial markets to function. The
Treasury has already done much of this.
(B.) Exchange certain existing MBS and CDOs
(say “Treasury Blessed “Obligations” or
“TBOs”), that are backed by at least 80% US
collateral, from any holder for Treasury
“warehouse receipts”. Make them more
attractive and less mysterious to investors,
auction them, and turn over the auction
proceeds to the receipt holders.
(B.1) This is subject to a minimum size of
the TBOs exchanged and of the issue involved.
Require, by law, issuers and servicers of
any TBOs acquired to submit a
report on the title and liens status of TBOs.
(B.2) Where feasible, combine the slices of
common TBOs to reduce complexity.
(B.3) Assign collection of TBO’s underlying
debt over 180 days delinquent to the IRS.
The IRS should be funded for this service.
(B.4) Waive all Federal tax (inheritance tax
too) on income from any instrument eligible
to be a TBO. Encourage the state and local
governments to so the same.
(B.5) Indemnify any holder of TBO from loss
because of title or lien, with specified in-
24
This point is part
of a enlighting description of relationship of money supply,
real output, and national debt.
“In
the real
world banks make loans independent of
reserve positions, then during the next accounting period
borrow any needed reserves.
The imperatives of the accounting system, as
previously discussed, require the Fed to lend the banks
whatever they
need.”
Mosler, Warren B. Soft Currency Economics, 1994. Available
at www.gate.net/~mosler/ frame001.htm. In this
case, reality follows Mosler’s theory, as
widespread bank deleveraging did not reduce the money
supply.
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demnity-payment timing. Treasury should
contract out title and lien checks before
auctioning the TBOs. The Treasury should be
funded for this cost.
(B.6) Contract out TBO analysis, valuation,
history, and public (internet) access to related
proprietary databases (e.g., those of Bear
Stearns and USATitle). Contract
the workout and collateral-management
services for TBOs under a unified and
consistent system. The Treasury should be
funded for this cost.
(B.7) Immediately payout the cash stream as
received from the TBOs to the receipt
holders. After acquiring a substantial part
of all US CDOs, an auctioning decision
should be made: will the TBOs fetch more as
individual bonds or as part of
a single homogenous issue. A holder of any
such single issue would receive a
share of all TB0’s cash stream. It is a
question of whether complexity trumps
homogeneity in the market. Auction off the
TBOs accordingly.
This is aimed at avoiding the collateral
losses discsses in section (4.) above.
(C.) Guarantee timely repayment of 80% of
certain classes of new private loans to US borrowers,
that meet certain minimum standards. These
classes are those supporting
key areas of the economy, like student,
home, and auto loans. Apply (B.1) through
(B.4) to the loans involved as if they were
TBOs.
(D.) Encourage the Financial Accounting
Standards Board to change SFAS 157. For each
fixed-income asset independently, the holder
should be able to book its value as the:
(D.1) current actual or inferred market
price (via the market price of a close asset and
a no-arbitrage argument), or
(D.2) present value of the holder’s intended
expected-marginal cash flow attributable
to that asset, using appropriate discount
rates and risk adjustments.
(6.2) Recommended Congressional Actions:
(E.) Congress accommodates (B.) above by
amending the Mortgage Forgiveness Debt Relief
Act of 2007 to waive recognition of ordinary
income for debt forgiveness on primary
residences only if:
(E.1) borrower obtains consent of a servicer
or substantial holder of the mortgage, or a
bankruptcy court, associated with the debt
in question; or
(E.2) demonstrates to the IRS that he or she
was the victim of any predatory lending.
This will remove the incentive to misuse
SCICS described in Subsubsection (2.1.3)
above, except where it is part of a
resolution or untoward lending.
(F.) Legislate liability for valuations in
major financial markets, including the major overthe-
counter markets and hedge funds. Hold anyone
who is responsible for valuing an
asset or liability in such markets
personally liable civilly and criminally for any substantial
valuation errors attributable to substantial
instances of: negligence, conflict
of interest, or fraud. This liability is to
anyone or entity who suffers from such valuation,
or who regulates the person or entity
responsible. A valuation that meets the IRS
“substantial authority” or the general
“reasonable man” tests will exempt the valuer.
But he or she will be responsible for being
aware of the general complexity of the valuation
involved to the extend of standard industry
practice.
(6.3) Recommended Federal Reserve Actions:
(G.) Allow banks to post TBOs as reserves,
up to some prudent limit.
(H.) In conjunction with the FDIC, require
all US banks to lend 80% of their previous 5-
year average in each major category of
lending, as a condition of maintaining their
FDIC insurance (with an exception process
for banks in special circumstances).
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(I.) For whatever period the Fed plans, pay
interest on member bank reserves only up to
the minimum reserve requirement for the
volume of demand deposits the bank has.
This will avoid an additional disincentive
to lend.
(6.4) Recommended Actions for all the
Entities Above
(J.) Hold a carefully-staged announcement by
the President, Treasury Secretary, Fed
Chairman, and Congressional Leaders. It
should be thoroughly researched and planned
for maximum psychological impact on the
financial markets before consumer and
investor psychological is further shaken by
widespread retail-store closings.
In implementing borrowing and guaranting of
borrowing, there is an important tradeoff for
the Government to ponder. The Treasury
reduces the money supply when it borrows and
Government agencies and private companies do
not. But the former borrows at a lower cost
than the latter.25
As
explained in Section (7.3) below, high inflation is a real
danger of the
bailout. Thus, Treasury borrowing
temporarily reduces this danger. However, guaranteeing
agency and private debt, instead of the
Treasury borrowing directly, may be justified because
it improves the liquidity of such debt and
it is the lack of such liquidity that is at the
heart of the financial crisis.
(7.) SHORT-TERM EFFECTS OF GOVERNMENT ACTION
(7.1) Relation of Money Supply to Fed and
Treasury Actions
In this analysis we will use the M1
definitions of the money supply. M1 is all the US-issued
cash and coins in circulation and all the
US-dollar demand deposits (checking accounts) in
US banks. M2 is M1 plus US dollar: (a.) time
deposits, money market mutual-fund shares,
money market deposit accounts, and overnight
repurchase agreements, all in the US, and
(b.) overnight Eurodollar deposits
(US-dollar demand deposits in foreign banks). If a bailout
delivers an amount of money to bond or
equity holders (other than US Government), then,
through the money-multiplier effect, that
amount is theoretically expanded.26
We also
calculated
the bailout effects on the M2 and MZM money
supplies and found that they were
proportional to the effects on M1, so we
have omitted them here.
But, the emergence of sweep time-deposit
accounts and other developments has made reserve
requirements less of a constraint and less
important, and thus banks are not lending
to their limit.11
The M1
money multiplier is the ratio of M1 to currency and bank
reserves,
and it has fallen from about 3.1 in 1987 to
about 1.2 now. The M2 money multiplier is the
ratio of M2 to currency and bank reserves.
It rose from 5.3 in 1987 to 8.6 in January 2007,
and then gradually fell to 6.9 in October
2008. These multipliers has little effect in the
short run, but might in the long run,
similar to speed limits for very unhurried save drivers.
Classical economic theory teaches: when a
borrower pays money back to a (nonbank)
lender, it: (a.) decreases the money supply
by reducing the borrower’s checking account,
and (b.) increases the money supply an equal
amount by increasing the lender’s checking
25
This is demonstrated
by 30-year Ginnie Mae bonds (with full-faith-and-credit
Government guarantee) trading with 2.6%
higher yield than Treasury bonds in November
2008. Similarly, Crown corporations have illustrated this
point by
borrowing at higher rates than the Crown,
e.g., the full-faith and credit bonds of the Canadian
Mortgage and Housing
Corporation (founded in 1944) has always
paid higher interest rates than The Bank of Canada.
26
The Fed’s reserve
requirements for demand deposits since 20 December 2007 have
been 0%, 3%, and 10% for deposits
under $9.3 million, between $9.3 and $43.9
million, and over $43.9 million, respectively.26
For time
deposits it is 0%.
Thus each bail-out dollar disbursed could
theoretically produce up to $10 of new demand deposits (and
infinite dollars of
time deposits), since that dollar becomes an
extra dollar of reserves when it is deposited, that will
support up to $10 of new
loans. These loans become new demand
deposits and currency. See footnote 15.
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account. If the lender is a bank, then the
money supply decrease does not reverse until it is
lent out again. In a cash rescue, the
borrowers do not repay and thus do not reduce their
checking accounts, but a nonbank bond holder
adds the government’s rescue payment
(money created out of thin air) to their
checking account. The money multiplier compounds
that increase in the money supply.
By law, the TARP must be funded by the
Treasury issuing additional debt. As the Treasury
buys assets from, or invests in (i.e., buys
preferred stock of), financial institutions, there
will be a rise in the demand deposits of
those institutions. This rise will equal the fall in the
demand deposits owned by the purchaser’s of
that additional Treasury debt. Hence, there
will be no immediate rise in the money
supply. But the money supply will rise as that new
debt delivers coupon and principal payments
in the future. More importantly, the additional
Treasury debt issues will increase the total
supply, and thus lower the value of such
debt, i.e., raise Treasury interest rates.
This in turn will raise all other US-dollar interest
rates and crowd out some private borrowing.
The Fed and the FDIC are also major players
in the bail out, and their rescue payments
will be pure increases in the money supply.
How much rates rise depends on many factors
that determine the elasticity of interest rates
with respect to the supply of Treasury debt.
A key factor is the amount of money created by
the Fed to accommodate the purchases of
Treasury bonds. But, increasing the money supply
creates inflation, which raises interest
rates. The Federal Home Loan Bank Board
(“FHLBB”) also borrows but that does not
count in the National debt.
(7.2) Bail Out’s Effect On The Money Supply
and National Debt
The New York Times Business Section featured
“Tracking the Bailout: The Government’s
Commitments” on 25 November 2008. It
reported in trillions:
(i.)
$1.7 Fed loans;
(ii.)
$3.0
preferred stock and mortgage purchases by
FDIC, Treasury, and FHBB ($0.60); and
(iii.)
$3.1 debt guarantees
by Fed, Treasury, and FDIC. This is consistent with
Government
pronouncements before and since, and it
totals $7.8 trillion. On 6 January 2008, the Congressional
Budget Office (“CBO”) estimated27
a $1.2
trillion 2009 budget deficit, excluding
the President-elect’s Stimulus Package; and
the New York Times reported: (a.) “Presidentelect
Barack Obama on Tuesday braced Americans for
the unparalleled prospect of “trilliondollar
deficits for years to come”;
and (b.) “Even
as he prepares a stimulus plan that is expected
to total nearly $800 billion in new spending
and tax cuts over the next two years”.
To calculate the impact of these Government
policies on the money supply and the National
Debt by 30 September 2011, we assume:
(Ι.)
no guarantees in
(iii.) are ever paid except the initial $100 billion
Treasury guarantee
on each of Freddie Mac’s and Fannie Mae’s
losses, which have already occurred;
(II.) loans in (i.) and purchases in (ii.)
do not ever increase from these levels;
(III.) financial bailout and stimulus
package are implemented in 3 years;
(IV.) CBO’s projection of $1.2 trillion/year
Government deficit continues for 3 years and is
financed by new debt;
(V.) debt service payments28
on the
Treasury new and previous National Debt for the next
three fiscal years totals 6% and 8%,
respectively, of such debt; and
(VI.) Fed’s announced $620 billion temporary
reciprocal-currency arrangements (swap
lines) with foreign central banks is
unchanged and fully used for 3 years.
Under these optimistic assumptions we
compute the classical-economic effects of the bailout
on the money supply and the National Debt in
three years. We do this for two polar
cases of Treasury borrowing. Congress can
choose Case 1: minimum increase in borrowing
27
Congressional Budget
Office. “The Budget and Economic Outlook: Fiscal Years 2009
to 2019”. January 2009.
28
All principal
repayments and interest payments due on debt during the
period in question.
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(in the National Debt) and maximum increase
in money supply (in M1). This is accomplished
by the Fed accommodating the Treasury in not
borrowing beyond funding the previous
National Debt and new deficits. Congress can
instead choose Case 2: minimum increase
in money supply and maximum increase in
borrowing. This is accomplished by
Congress authorizing a large-enough increase
in the National Debt (beyond the deficit and
the bailout debt already authorized) in
order to “soak up” both: the new money directly created
by the bail out, and the debt service on
that new debt.
CASE 1 CASE 2
(All $ amounts in trillions) no additional
borrowing borrow enough to
to soak up money soak up new money
created by bailout created by bailout
M1 Money Supply in 3 Years
Fed disbursing (creating) money for:
loans & credit lines $ 1.710 $ 0.000
commercial paper 1.600 0.000
US-dollar swap lines 0.620 0.000
buy AIG assets 0.053 0.000
Subtotal money created directly by Fed
bailout 3.983 0.000
Treasury debt service (pay out) on debt
funding
previous National Debt 0.064 0.064
CBO projected current deficit for 3 years
0.216 0.216
President-elect’s proposed Stimulus Package
0.048 0.048
direct Treasury-bailout debt 0.054 0.054
soak up direct Fed-bailout rise in M1 money
0.000 0.366
Subtotal money created by debt service 0.382
0.748
Subtotal new money before money multiplier
4.365 0.748
Additional M1 money from M1 multiplier 0.873
0.150
Total increase in M1 money supply 5.238 =
364.8% rise 0.898 = 62.5% rise
Existing M1 money supply on 30 Sep 2008
1.436 1.436
Total M1 money supply after bailout 6.674
2.334
National Debt in 3 Years
Treasury borrowing for:
TARP $ 0.700 $ 0.700
guarantee of Freddie Mac 0.100 0.100
guarantee of Fannie Mae 0.100 0.100
debt issued to soak up rise in M1 money
0.000 4.365
Subtotal new bailout-direct & soak-up debt
0.900 5.265
Treasury debt to fund
previous National Debt 0.802 0.802
CBO projected current deficit for 3 years
3.600 3.600
President-elect’s proposed Stimulus Package
0.800 0.800
Subtotal new debt to cover debt service
5.202 5.202
Total new debt in 3 years 6.102 = 60.9% rise
10.467 = 104.4% rise
Existing National Debt 10.650 10.025
Total National Debt after bailout 16.127
20.492
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$10.03
old
debt
$3.60 deficit at
current pace
$0.90 bailout debt
$0.87 M1 multiplier
$3.98
Fed direct bailout
spending
$1.44 old M1
money supply
364.8%
rise to $6.67
M1 Money Supply
CASE 1: SMALLER DEBT & LARGER MONEY
SUPPLY IN 3 YEARS
(all $ amounts in Trillions)
National Debt
debt service on: old debt
service $0.06, deficit for
= 3-years $0.216, Treasury
direct bailout debt $0.05,
Stimulus Package $0.48
60.9.3%
rise to $16.13
$0.80 serve old debt
$0.80 Stimulus
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(7.3) Likely Effect of Bailout Funding and
Limitations of Treasury Borrowing
To put these Cases 1 and 2 in perspective,
US Gross Domestic Product (“GDP”) is $14.5 trillion
per year. If the real output of goods and
services (i.e., output adjusted for inflation)
does not rise in the next three year, a
larger money supply will be chasing the same or less
goods and services. We have to add to this
whatever increase in money supply that the Fed
$10.03
old
debt
$3.60 deficit at
current pace forecast
by CBO
$1.52 old M1
money supply
104.4%
rise to $20.49
62.53%
rise to $2.33
National Debt M1 Money Supply
CASE 2: LARGER DEBT &
SMALLER MONEY SUPPLY
IN 3 YEARS
(all $ amounts in Trillions)
$3.98 Fed direct
bailout
spending
$4.37 debt “soaks up”
new money from
Fed bailout & debt
service on it
$0.90 bailout debt
$0.80 Stimulus
debt service on the = $0.80
debt service that funds
previous National Debt
$0.75
= debt service on:
previous National
Debt $0.6, 3-year
deficit $0.22,
Stimulus $0.05,
soak-up debt
$0.37
$0.15 M1 money
= multiplier
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creates to accommodate the bond issues that
the Treasury uses to help fund the bail out.
This is the demand-pull that spells
continued inflation, and thus the expectation of inflation,
both of which raise interest rates. If
things turnout worse than we assume in the second
paragraph of Subsection (7.2) for the next
three years, the money supply and Treasury
debt will grow even larger. Important worse
outcomes in (6.2) include: more of the myriad
Government guarantees in (iii.) above come
due, more firms are bailed out, the annual deficit
grows, and interest rates rise.
It is the prospect of these changes that
lead to the suggestion in Section (6.) (B.) above: any
large-scale CMO and CDO purchases that maybe
contemplated should be paid for with
warehouse receipts
instead of money.
Note, such comprehensive purchases are not part of
the current bail out enumerated in (i.),
(ii.), and (iii.) of Subsection (7.2) above from Treasury,
Fed, or FDIC. The receipts approach will
avoid raising the money supply even more
than calculations in (7.2).
Congress has a choice between: Case 1
(364.8% higher M1 money supply and 60.9%
higher National Debt), Case 2 (62.5% higher
M1 money supply and 104.4% higher National
Debt), or of something in between those two
polar cases. But there are limits to the market’s
appetite for Treasury debt and thus the
feasibility of Case 2. A larger supply of Treasury
bonds will lower the market price of those
bonds, and thus by definition raise interest
rates, distinct from the rise in interest
rates caused by inflation. Furthermore, massive new
Treasury debt will crowd out private
borrowing that supports production and consumption.
Thus, Treasury borrowing, to reduce the
money supply, will reduce the goods and services
being chased by the money supply, and thus
raise inflation still further. The larger Case 2
debt minimizes M1 money supply growth at an
average of 17.6%/year compounded for
three years, but simply postpones creating
more money.
If the GDP does not grow over the next three
years, then there will be at least 17.6% inflation/
year. Since interests rates are usually
greater than inflation, his suggests that much
inflation in the period. The Case 2 National
Debt soaring 104.4% in three years will flood
the market and lower the price of Treasury
debt, i.e., raise interest rates. These two effect
point to between 10% and 20% short-term
interest rates (e.g., 3-month Libor) sometime in
the next one to three years. That in turn,
will raise the interest cost of financing the
$20.492 trillion (extant in 3 years under
Case 2) National Debt to between $2.049 and
$4.098 trillion/year, which is 13.1% and
26.2%, respectively, of 2008 GDP. That compares
with about $412 billion of interest expense
in 2008.
I was asked to predict GDP, employment, and
other economic statistics. They are not as
easy or direct to compute as money supply
and National Debt from the Government’s current
bailout commitments. However, my best
estimate (assuming the Government does not
restore consumer and investor confidence
soon), is as following. First, deficits as a proportion
of tax revenue unseen since WWII. Second, 10
to 20 for almost everything in one to
three years: 20% of retail-store units
close; 10% to 20% unemployment, inflation, and 3-
month Libor; 10% to 20% more poverty and
crime; $20 per barrel oil; and 10% less GDP
per capita. The latter two estimates are
adjusted for inflation from 1 October 2008 prices.
(8.) LONG-TERM EFFECTS OF GOVERNMENT ACTION:
TIPPING POINTS
If any of the scenarios described in
Subsection (6.) above materializes, then the credit markets
and world opinion will expect prolonged
inflation in the US. This will likely provoke
two successive psychological-tipping points.
These tipping points are similar in some ways
to the fear of a bank failure that becomes a
self-fulfilling prophecy, but are likely to be
based on more-realistic fears. The mere
prospect of these tipping points can cause investors
to act before it is justified by economic
circumstances. This would cause foreign investors
to dump US debt or dollars before others do,
accelerating the run into such a selfFinancial
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10 January 2008
fulfilling prophecy.
(8.1) Foreigners Dump US-Dollar-Denominated
Debt
Foreigners will stop wanting to hold US
dollar-denominated debt because its value will be
expected to dissolve with high inflation. To
not hold such debt, they must sell it, i.e., exchange
it for US bank demand deposits. This implies
US Government debt prices will fall,
which raises US interest rates by
definition. It also leaves foreigners with far more US
dollars
than they hold in equilibrium, which implies
that they will sell the dollars for foreign
currency. Thus, the dollar will fall sharply
against foreign currencies and that raises the
cost of imports and thus raise inflation
still further. New reports are starting to report the
first tendencies in this direction. On 8
January 2008, the International Herald Tribune
Business with Reuters section had an article
entitled “US debt is losing its appeal in China”.
It included:
"All the key drivers of China's Treasury
purchases are disappearing," said Ben Simpfendorfer, an
economist
in the Hong Kong office of the Royal Bank of
Scotland. "There's a waning appetite for dollars and a
waning
appetite for Treasuries. And that
complicates the outlook for interest rates." It reported
that about 70% of
China’s public holding of foreign debt is US
dollar debt, i.e., about $1.43 trillion, and that China is
expected
to decrease it foreign debt holdings.”
(8.2) Foreigners Dump US Dollars
If the bailout leads to fear of high
inflation, as suggested in Subsection (2.2) above, and US
dollars are perceived by foreigners as
falling against other currencies long term, then they
will not want to hold US dollars. To stop
holding dollars, foreigners will buy US goods and
services with those dollars. That might seem
fine for US producers, but the US economy
will suffer “Seigniorage Shrinkage".
Seigniorage is the profit a government makes on the
money it creates, i.e., the value of the
things it buys with the money it circulates (by buying
goods and services) minus the cost of
creating the money.
Seigniorage Shrinkage works as follows.
Until now, foreigners have produced goods and
services, which were consumed in the US and
paid for in US dollars which were created at
very low cost. But, the US sends foreigners
less goods, services, and financial assets in return.
The difference is that part of the US
merchandise trade deficit held by foreigners as
US dollars (paper money, coins, and US bank
demand deposits) and used as a medium of
exchange. This is a temporary gift from
foreigners to US consumers, or more accurately an
open-ended putable loan with a “negative
interest rate” equal in magnitude to US inflation.
If that magnitude gets too large or
foreigners expectations of it get too large, they will
switch
to other currencies as a medium of exchange.
To do this, they will buy US goods and services
with US dollars that the US cannot consume.
This reverses the beneficial seigniorage
of the past, which in turn, lowers the US
standard of living.
Foreigners spending US currency and demand
deposits in the US will not increase the US
money supply (since they are already counted
in the money supply). But it will create demand
pull on domestic prices, since it will be
chasing US goods and services instead of facilitating
foreigner-to-foreigner transactions.
Note, much of this foreign-circulating US
currency is paper money and coins (rather than
demand deposits). The Fed estimates $778
billion of currency is in circulation, but does
not have an accurate measure of this. About
90% of all $100 bills printed are sent to the
New York Federal Reserve bank, mostly for
shipment overseas. Several academic studies by
the Federal Reserve Board of Governors and
by private economic-policy research institutes
like The National Center for Policy Analysis
in Washington, DC, estimate foreign circulation
of paper money and coins at between 40% to
60% of the total. Whatever proportion of that
being spent in the U.S would raise the money
supply by 20% to 30% of that proportion.
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That adds to the inflationary pressures
explained above and points toward hyperinflation.
(9.) CONCLUSION
The US is facing the possibility of a
classic sever recession or depression, which is based
entirely on investor and consumer
expectations that there will be one. Such recession or
depression are self-accelerating and
self-fulfilling, and can only be diverted from their natural
and disastrous course by the widespread
expectation of decisive Government action. In
particular, the Government should make a
single dramatic presentation which convinces
the American people that it will not happen.
This means the public must be convinced that
more-than-sufficient actions will be taken
by all the relevant parts of Government, working
in unison, to prevent it.
This must be done before the next obvious
harbinger of depression becomes apparent: the
mass closing of retail stores across the US.
The everyday spectacle of familiar retail stores
out of business will greatly reinforce the
current consumer and investor panic, that is the
heart of the financial crisis, and will make
it far harder to dispel that panic. Such closings
are likely in the first quarter of 2009
since ocean shipping of dry raw materials has fallen off
sharply in the last six months and container
ship rates (mostly for finished goods) are starting
to plummet. Less raw material shipped to
producers in the second half of 2008
implies less finished goods shipped to
stores in 2009. This slowdown in raw-material shipping29
is working its way into finished-good
transport, as container ship rental prices
reached an all-time low in the third week of
December 2008 and unprecedented amounts of
container shipping are being laid up.30
This
suggests retail stores will do far worse in 2009
than even the record-low sales of November
and December 2008. The International Council
of Shopping Centers estimated that sales
fell 2% in each of those months (largest since records
were first kept in 1969), and that 148,000
US stores will close in 2008, which shrinks
the total by about 3%. The MasterCard
SpendingPulse unit reports record 5.5% and 8%
year-over-year drops in those months,
respectively. Absent immediate and decisive Government
action, retail stores will be faced with a
two-pronged disaster in 2009. Consumers
will purchase even less and stores will have
much smaller shipments of goods to sell. This
will further devastate both consumer and
investor confidence, which is the stuff that depressions
are made of.
The nine policy actions in Section (6.), and
perhaps others, should be woven into a carefully-
staged and researched presentation to the
public. As much effort should be committed
to that presentation as to the actions
announced. It needs to be a psychological turning
point for investors, employees, and
consumers. Such a turning point will solve the crisis.
29
The Baltic Dry Index
BALDRY is the price measure of containerized ocean freight,
produced by The Baltic Exchange in
London. It fell 93.2% from 11,648 to 784
between 22 May to 22 December 2008. The ConTex index,
produced by The
Hamburg Ship Brokers Association, fell from
974 in May 2008 to 371 in the third week of December 2008.
30
On 22 December 2008,
Bruce Barnard reported in the The Journal of Commerce Online
that container-ship charter
prices (adjusted for inflation) reached an
all-time low. Rental of a 3,500 TEU gearless Panamax
(container) carrier dropped
from $25,000/day to $15,000/day just in the
third week of December 2008, and rental of a 2,750 TEU sub-Pananmax
(container)
carrier fell from $19,500/day in September
2008 to $10,500/day in December 2008.
|
|
|
Jaime
Cuevas Dermody,
Principal
Financial Engineering LLC
1855 Lake Drive, Delray Beach, FL 33444
561 278-4100
jaime@fe.net
Hyperinflation & Policy
(0.) PREAMBLE
This paper was originally prepared for a talk on “The
Dangers of Printing Too Much Money” given on 17 June 2008 to
the Investment Management Institute Conference held at the
Avenue Hotel in Chicago. In that talk I said that
every major Wall Street investment bank was bankrupt for the
reasons given in Subsection (1.3) below. Many in the
audience since apologized for ridiculing that remark and
suggested making the talk into a paper updated for recent
events. In doing so, I have focused on “market
failure” in the CMO (collateralized mortgage obligation)
market, its spread into a general credit crisis,
deleveraging, and how Government policies can resolve the
current financial crisis.
The subprime mortgage share of all U.S. home mortgages was
$58.0 billion or 10.2% in 1995 and $332.0 billion or 8.8% in
2003.
If we add the surge in Alt-A and home-equity lines to the
subprime mortgages, we find its share was $1.1 trillion or
15% in 2001 and $1.4 trillion or 48% in 2006.
The US house-price bubble peaked in July 2006 and fell to
21.77%, on average, across the U.S.
This fall lead to enough home-mortgage defaults by March
2007 to reduce by about 90% and 100%, respectively, the cash
flows to two prominent Bear Stearns Funds based on leveraged
CMO positions. In June 2007, those funds began to
close down. This spread panic progressively into the:
rest of the U.S. CMO market in less than a month, other
credit markets worldwide, and all the other financial
markets by September 2008. The essence of this
financial crisis is the general lack of investor confidence
in the financial institutions and the information they
provide. These institutions include: legal and
accountant firms, rating agencies, credit enhancement
providers, commercial and investment banks, as well as,
Government regulators and officials.
In Section (1.) and (2.), I explain how the CMO crisis began
and how it spread, respectively. Section (3.)
discusses reduction in loans outstanding from money-center
banks. Section (4.) makes 11 recommendations.
First is a set of 10 specific Government actions that need
to be taken, and as importantly, some that should not be
taken. Second is one recommendation on the
announcement and implementation of first ten steps, in order
to obtain an effective psychological impact on the markets.
The latter is as crucial as the former, because it must
restore investor confidence in those institutions and the
information they provide. Without that confidence, the
financial markets will not function. Sections (5.) and
(6.) discuss the short-term and long-term consequences,
respectively, of Government action, or lack there of.
Section (7.) is a brief conclusion.
(1.)
THE SPARK: “MARKET FAILURE” IN CMO MARKET
Market failure is the economic condition defined by a free
market not achieving efficient allocation of scarce
resources. This efficient allocation is known to
economists as a “Pareto- optimal allocation”, and is defined
as an allocation for which no reallocation can make any
market participant better off without making another worse
off. It is equivalent to achieving a price
equilibrium, in which everyone is holding the set of assets
they want given the market prices and their initial wealth.
Theoretically, in such an allocation, investors who are
willing and able to pay the most for a given asset, like a
CMO, are left holding it.
This definition of market failure is vague. Some
economists and commentators are prone to describe a market
as suffering from market failure, when in fact that market
merely has significant transaction costs that are overlooked
and cause the misallocation. This is not surprising
since most economics lectures start by assuming no
transaction costs, no taxes, and perfect information.
The current market for CMOs suffers from three important
types of transaction costs that, in part, explain the lack
of trading and therefore of apparent market failure. I
will label these types of transaction costs in practical
language, rather than in the words of microeconomists:
asset-specific complexity, general-valuation complexity, and
lack of clear property rights. These transaction
costs are explained below in Subsection (1.1) and their
effects on the financial markets are described in Subsection
(1.2) and Section (2.) below.
(1.1)
TRANSCATION COSTS
To understand the effects of these transaction costs on the
CMO market, let us start from the simple and obvious premise
that any particular bond of any CMO is valued by an investor
based on his or her expectations of that bond’s future cash
stream to them.
(1.1.1) Asset-Specific-Complexity Transaction Cost
CMOs have complex cash flows by their very nature. A
CMO is the right to the home-mortgage repayments of
thousands of homeowners (typically for the next 15 to 30
years) net of the collection costs (e.g. the servicing of
the performing loans and the workout, foreclosure and/or
maintenance costs of any nonperforming loans). In
general, homeowners have the right to prepay any part or all
of their mortgage without penalty. This right is an
American call option (that the lender in effect sold to the
borrower) on the mortgage, which is embedded in the mortgage
and paid for with a higher interest rate than would
otherwise be the case.
To value this cash stream, one must form a probability
distribution over the future behavior of thousands of
borrowers, whose mortgages are part of a single CMO.
This behavior is affected by several primary factors,
including home values and homeowners ability and willingness
to make mortgage payments. These primary factors, in
turn, depend on future changes in secondary factors:
(i.) employment rates and geography, (ii.) interest rates,
(iii.) construction costs, (iv.) municipal services,
(v.) crime rates, and (vi.) taxes. These factors
change both the CMO cash stream, via their relation to the
propensity for prepayment and default, as well as, the
economic impact of such on the CMO holders, e.g., the
reinvestment rate for prepaid principal and the contagious
loss in collateral value from home abandonment. This
creates intricate feedback loops that are difficult to
predict in the short run, and far more difficult to predict
over the entire 15 to 30 years of a typical CMO cash stream.
The models that were used to value CMO assumed that
delinquent home loans would be managed to the benefit of CMO
holders. This involved workout or orderly foreclosure
and resale of the homes. But the sheer volume of
delinquent mortgages since 2006 has overwhelmed the ability
of bankers and mortgage servicers to cope. This has
greatly reduced collateral value and lead to a contagion of
foreclosures. Bankers and servicers are not able to
efficiently deal with managing the delinquencies and
surrendered collateral.
A little-thought-about, but now-crucial, consideration in
the value of extant CMOs is the shortage of competent
personnel to assess and negotiate “work outs” or orderly
foreclosure and resell collateral of delinquent mortgages.
In the best case a delinquent mortgage is either:
(i.) modified so the borrower
remains in and maintain their homes via mortgage
modification or exchange for a rental agreement (in a way
that benefits both the
home owner and CMO holder), or
(ii.) foreclosed and the home
maintained and resold for its market value in an orderly
manner, without damage, disrepair, unnecessary ill effects
on neighboring homes,
or interruption of insurance and property taxes.
In the worst case, the absence of such personnel has
resulted in needless home abandonment, which in turn has led
to lower property values and contagious abandonment of
neighboring homes. This has caused social trauma for
the home-owning families involved, as well as, reduction in
mortgage-collateral value as homes fall into disrepair, are
vandalized, insurance and property taxes are unpaid, and
municipalities seize homes.
Most home-mortgage companies and servicers appeared
competent at originating, processing, and servicing home
loans home when sales were booming. However, they do
not have the expertise, staff, or organization to deal with
workouts and foreclosures at the current scale. In
general, such organizations lack even the ability and
inclination to obtain and manage the contractors needed to
perform these services.
One scary possibility is that layed-off mortgage salespeople
become mortgage delinquency managers attempting to perform
the tasks in (i.) and (ii.) above. They would likely
mirror the horrendous 1980s performance of out-of-work
savings and loan officers who become Resolution Trust
Corporation officers. In the period from the 1986
failure of the Federal Saving & Loan Insurance Corporation
until its related assets were sold in 1995, $152.9 billion
of the $519.0 billion in thrift assets acquired were lost.
This cost the Government $123.8 billion and the owners and
creditors of 1,043 failed thrift institutions $29.1 billion.
That is $184.0 and $43.4 billion, respectively, in July 2008
dollars. This occurred in a favorable business
environment in which GDP rose every quarter and GDP,
adjusted for inflation, rose every quarter but one.
Inflation (Commerce Department GDP deflator) averaged 2.4%
in that period.
The highly-heterogeneous nature of CMOs is another part of
this complexity. There are many basic types of home
loans, often in the same CMO: fixed rate, floating
rate, hybrid (part fixed and float), low “teaser” fixed rate
turning to higher fixed or floating rate, non-amortizing
balloon payment loans, graduated payment, negative
amortizing, “no documentation”, and “no-income
verification”. This heterogeneity continues with the
different homes that are mortgaged and the particular
circumstance of those mortgages, including quality of the
documentation involved, local real-estate markets, the
income and economic circumstances of the borrower, and state
laws, etc. This complexity is sometimes exacerbated by
the fine partition of the CMO into many pieces. Some
of this partitioning creates additional risk, as in
principal-only and interest-only bonds. When part or
all of a CMO is paid off early, the principal-only bond
holder is helped by earlier payment of principal,
undiminished for time value of money, whereas the
interest-only bond holder is hurt by losing their payments
for that part of the loan.
Modeling CMO prepayment is a complex exercise involving
probability distributions across up to 30 years of changes
in these many factors, and the effect of those changes on
prepayment and default behavior. These effects are in
turn a function of the many loan types enumerated above.
Hence, it is difficult for a CMO investor to understand both
its mechanics of the promised cash stream and a probability
distribution over that cash stream. I recently
reviewed a 15-page bid on valuing the bonds from a
particular CMO. The bid was $240,000 to construct a
model of the cash flow, and $64,000/month to maintain it.
All of this increases the risk and cost of trading CMOs, to
an even greater degree than the heterogeneity of the
municipal and corporate bond market complicates those
markets. It also makes investors more leery of coping
with CMOs when their value changes in unexpected ways,
because it is so difficult to appreciate their circumstances
or to evaluate alternative strategies, e.g., holding,
selling, or hedging.
(1.1.2) General-Valuation-Complexity
Transaction Cost
A fundamental task of accounting is to assign a useful
current value to an asset. Since November 2007, the
Financial Accounting Standards Board’s Statement of
Financial Accounting Standard (SFAS) 157 has required firms
to mark to market financial assets. The lack of a
liquid market in CMOs has made this difficult and led to a
disparity of values among different holders of the same
instrument. The theoretical foundation behind SFAS 157
is problematic.
The value of an asset to a firm depends in part on how it
intends, and how it is able, to make use of that asset.
In many cases, a firm intends to sell the asset and cannot
make economic use of it in any other way. Consider a
medical supply house holding an X-ray machine, with no
ability to use it for anything but selling it. In
contrast, a radiologist can use it either as a diagnostic
tool, and thus earn a stream of marginal revenue from it, or
sell it. Suppose the medical supply house can
profitably sell it for $10,000 after an average $1,000
of marketing costs, but the radiologist can increase the
present value of his or her medical-practice cash flow by
$20,000 with it. Further suppose there is a tax law
that provides accelerated depreciation or tax credit on the
machine for doctors, but not wholesalers, worth $1,000 in
present value. Then the machine’s economic value to
the supply company is $9,000, but to the radiologist its
value is $21,000.
Real estate workers often use an analogous concept of
“highest and best use” to describe the particular use of a
property in valuing it. Note that these two values do
not violate the economic “law of one price”, but rather
explain why the medical supply company is happy to sell a
machine, and the radiologist is happy to buy it, for a
$10,000 price. Some firms can never use an advantage
associated with an asset, while others can. Such
advantages include economies of scale or scope, marketing,
technology edge, and regulatory or tax advantages.
Thus, the net value of an asset and its associated tax
credit differ across firms, and this explains why some firms
will sell it to others. In Section (3.) below, I
suggest changes to FASB 157 that will more closely reflect
economic reality and will eliminate this accounting-driven
part of the CMO crisis.
(1.1.3) Property–Rights Transaction Cost
There are a variety of state “anti deficiency” laws
regarding borrowers’ obligations when a
repossessed-home-loan balance exceeds the liquidation value
of its collateral. They were first introduced during
the Great Depression. In some states like California
[CCP 580(b)], CONTACT _Con-3F4CE9CBC7 \c \s \l New York
[RPAPL 1371], Arizona [ARS 33-729(A) and 33-814(G)], and
North Dakota [32-19, 1-07], borrowers are not liable for
more than the collateral of a principal residence. In
California, this applies even if the owner-resident has
converted the home to a rental unit.
Borrowers there have an incentive to surrender their (house)
collateral in complete satisfaction (“SCICS”)
of the loan, if they can buy an identical house across the
street for substantially less than the loan balance on their
home, or rent such a house at a rate that reflects this
lower value. But, in the past, there was a strong tax
impediment to this incentive, which supported the value of
CMOs. SCICS implied immediate (“forgiveness-of-debt”)
ordinary income equal to any loan balance in excess of the
home-collateral liquidation. A borrower who chose to
SCICS had to pay federal income tax for that year on such
excess.
The S&P/Case-Shiller U.S. National House Price Composite
Index (CXSR), of the largest 20 metropolitan areas in the
U.S., declined 21.77% from its peak in July 2006 to
September 2008, which is the latest available. The
greatest declines were in Phoenix, Las Vegas, Los Angeles,
Miami, San Diego, and San Francisco areas, which had 38.52%,
37.44%, 36.11%, 35.79%, 34.11%, and 33.13% declines,
respectively, in that period. Thus many borrowers in
some states have an incentive to SCICS, which used to be
retarded by the federal taxes mentioned in the previous
paragraph. However, in December 2007 Congress passed
the Mortgage Forgiveness Debt Relief Act of 2007, which
waived such tax on principal residences. This removed
the impediment, thus increasing SCICS, reducing the value of
CMO cash streams, and adding even more complexity to their
valuation.
Investors must now construct more subtle probability
distributions over collateral surrender, for that part of
the (often thousands) of home mortgages in a given CMO which
are in states that allow SCICS. There are winners and
losers from this new tax law. Current home owners in a
position to use SCICS win. Bond holders lose,
including the average citizen who has a pension or insurance
policy that owns CMOs. Their retirement income will be
reduced. Anyone who will apply for a home mortgage in
the future will lose, in the form of higher interest rates
that stem from the added risk of SCICS unbridled by taxes.
To the limited extent that this transaction cost feeds the
above-mentioned “market failure” (which reduces real
output), it make every citizen poorer and less secure.
One sign of this cost to home owners is the refusal of some
large investors to buy CMOs that include California home
mortgages.
(1.2) IMPACT OF TRANSACTION COSTS ON CMO MARKET
The complexity, accounting, and property-rights transaction
costs above have had a particularly detrimental effect on
the CMO market. Many of the CMOs are held by
institutions and investors who lack the mathematical
expertise to model CMO cash flows. The original models
used to price new CMOs before June 2006 (whether those of
the investor or the investment banker selling them) had
particular probability distributions over home prices, and
assumed an economic environment with the tax impediment
described in Subsection (1.1.3) above. First, the
realization of those home prices turned out to be in the
lower percentiles of the probability distributions used.
Second, the tax-impediment vanished in 2007, which cheapened
CMO with mortgages in states that allowed SCICS, and it
raised the complexity of modeling CMOs.
Many CMO investors and potential CMO investors lost faith in
the models, and have even less faith in the more-complex
models now required. They want out of their CMO
positions. The huge number of such CMO holders has
created an overhang of supply in the market, which leads
even mathematically-sophisticated and well-capitalized
investors to fear that whatever the current price is, it
will go lower.
This fear is accentuated by the recent experience of exactly
such investors. Last year, many investors correctly
determined that some high-quality CMOs were selling for less
than the present value of any realistic probability
distribution of their future cash flows, and they purchased
such CMOs, often with leverage. As the events
described above unfolded, CMO prices fell even farther below
any rational valuation given those events. Most of
these sophisticated investors are hedge funds or proprietary
desks that must mark their CMOs to market. Thus, they
have been showing their investors or parent organizations
serious losses, which together with the lack of market
prices, have cut off their access to equity capital and
borrowing. This despite the fact that the cash flow of
these marked-down CMOs, from their purchase by such hedge
funds to their maturity, makes them very profitable (on a
cash-flow basis). Hence the very market participants
who might bring price discovery and liquidity to the market
(and make a profit in the process), and thus Pareto
efficiency, are out of the game. This helps explain
the lack of a market in CMOs and what passes for “market
failure”.
(1.3)
LEVEL III ASSETS
The problems described above are crystalized in the Level
III assets held by major financial institutions. CMOs
are now Level III assets. But there are many Level III
assets beyond CMOs that suffer from the same sorts of
transaction costs and are also unduly disparaged in the
credit markets.
Level I assets are those assets for which there is a
liquid-market price available. Level II assets are
those assets that can be valued by a close proxy asset and a
no-arbitrage argument. Level III assets are those
assets for which neither of these is available. The
latter require complex mathematical models and many
assumptions. At best, hedge-fund managers and the
heads of the proprietary trading desks, that own these
assets, have good insight into their true value. In
particular, internal and external auditors, risk managers,
as well as, rating agencies, are generally clueless about
their worth. Many Level III assets have been grossly
over-rated by rating agencies. As if that were not bad
enough, those same managers or heads that are responsible
for marking their Level III assets to market, are paid fees
or bonuses based on how much their Level III assets rise in
value each year. Thus many Level III assets have been
marked far above their market price if their market price
could be realistically divined. The CMO market failure
immediately focused investors on these problems and
virtually stopped trading in Level III assets.
The major Wall Street investment banks, and other financial
institutions that have substantial Level III assets and high
leverage, have over valued Level III assets to such an
extent that they are bankrupt under any accurate method of
accounting. They may own CMOs directly and/or have
exposure to them via credit-default swaps. Note that
mathematical complexity masks reality enough so that many of
the CMO were grossly overvalued by such proprietary desks,
while other firms have recently marked the same CMOs at
values far below a rational present value of their cash
flows. Sheer uncertainly is added to the already-scary
credit markets by firms changing the Level III
mark-to-market values with unpredictable adjustments and
timing.
Examples in July 2008 of the ratios of Level III assets to
equity reported by The Financial
Times website FT.com ($s in billions) were: Citigroup
ratio 1.05 = $135/$128; Goldman ratio 1.85 = $72/$39;
Morgan Stanley ratio 2.51 = $88/$35; Bear Stearns
ratio 1.54 = $20/$13 billion; and Merrill Lynch ratio
0.38 = $16/$42. Even if somehow the illiquidity and
over-valuation of these assets has not made them in fact
bankrupt, they are in danger of spiraling to such a state in
a few days if the markets and their psychology turn much
more unfavorable, because they will not be able to trade.
No counterparty will trade with them if any of several
credit-worthiness measures drop below
contractually-specified levels (a “credit event”) in any of
their hundreds of bilateral ISDA (International Swap Dealers
Association) agreements. These measures involve
mark-to-market values and various financial ratios.
Worse yet, failing firms may default or delay payment on
some obligations to otherwise solvent firms, leading to a
cascade of insolvencies.
(2.) CMO & LEVEL III PROBLEM SPILLOVER TO ALL
FINANCIAL MARKETS
(2.1) Spillover
to Financial Institution’s Balance Sheets
There is an enormous quantity of Level III assets (including
CMO assets backed by US home mortgages) widely held by the
major participants in the US credit markets. These
participants include the commercial and investment banks,
hedge funds, insurance companies, and other financial
institutions around the world. Hence, the fall in
Level III-asset prices (where these prices can be found),
the lack of liquidity and price discovery, and the
consequent uncertainty have combined to impair the balance
sheets of these participants. This has reduced the
ability of many prominent firms to act as counterparties to
trades in the general credit markets.
Some of this risk of CMO- and other Level III- asset value
has been passed from one financial institution to another
via credit-default swaps (CDS). The writers (issuers)
of those CDSs did not factor the transaction costs described
above into their valuations, and in general grossly
under-estimated the risks. This had two pernicious
effects. First, it gave comfort to many investors
supplying capital to firms that purchased CMOs, because much
of the ultimate risk was insured, via these CDSs, by firms
with high credit ratings. The most prolific issuer was
London-based AIG Financial Products, which is a subsidiary
of previously-AAA-rated AIG, that guaranteed its
obligations. Second, it further spread potential
insolvency to firms that were not otherwise heavily involved
in CMOs, such as AIG and many of its counterparties.
(2.2)
Balance Sheet Effects on Falling and Irrational Prices
The shock of such firms (like Goldman Sachs, Morgan Stanley,
Lehman Brothers, Bear Stearns, and AIG) suddenly being
unworthy to trade with in September 2008, has contributed to
a loss of investor faith in many of the institutions and
mechanisms of the general credit markets. These
investors wonder who they can trade with safely and just
what they can count on after such a fall from grace of the
financial titans. They have been fooled and
disappointed by: investment banks who sold CMOs,
mathematical models that valued CMOs, internal and external
accountants and rating agencies that determined or opined on
their valuations, as well as, investments in firms and funds
that were invested in firms that invested in CMOs.
This has stifled many normal commercial activities of the
credit markets, and brought on the specter of their
bankruptcy or Government bailout to many prominent firms in
those markets.
A frightening consequence of this loss of faith is its
contagion to almost all non-government financial
instruments: debt, equity, and commodity. That
has led to a write down of the value of privately-issued
financial assets across the board, which has weakened
corporate and hedge-fund balance sheets, and thus greatly
impaired commerce. This will be an economic disaster
if it persists. The switch of TARP policy in October
2008, from buying illiquid assets of financial institution
to injecting capital into those institutions via preferred
stock purchases, recognized this phenomena and its gravity.
There is great demand for US Treasury bonds as the other
markets are becoming far less liquid and investor are
panicking. But even that market is adversely affected
by panic, in that hedge funds and proprietary traders do not
have sufficient capital and borrowing capacity to arbitrage
large mispricings in the Treasury market. On 30
October 2008, on-the-run 10-Year Treasury bonds yields were
40 basis points lower than yields of such off-the-run bonds,
and the 30-year Treasury bond yield was 50 basis points
higher than the 30-year swap rate for 3-month Libor.
This crazy relative pricing is explained in part by traders
being forced out of positions by margin calls, redemptions,
and reduction of credit lines, all stemming from the
distortions of mark-to-market accounting. They held
positions that were very profitable arbitrages, if they
could stay in them to benefit from the cash flow, but they
had to unwind those positions. That in turn pushed
prices further out of line, making the arbitrage even larger
for anyone with the capital to hold the positions.
This is the key to spiraling down and irrational
relative-price levels, which has paralyzed the markets.
Many investors are not valuing investments through the
normal assessment of their probability distribution of that
investment’s future cash flow, but rather on how they think
other investors will value them. It is as if each
investor is saying “I am not irrational, but I am choosing a
strategy that is optimal, given that I think the other
investors are panicked into irrational behavior”. This
perceived irrationality leads investors to not buy assets
that are available for prices far under any rational
assessment. Such psychology is the heart of the
economic crisis. While the specific steps enumerates
in this paper to improve the credit markets are important,
none of them will help if this psychology is not reversed.
That suggests the announcement and implementation of those
steps, and/or other such steps, is as important as the steps
themselves. The Government must carefully craft and
stage managed the presentation of all its steps at one time,
to impress and dazzle the financial press and the markets
with the Government’s understanding of and solution to the
credit crisis. If the markets have faith in the
Government’s solution, then it will be a self-fulfilling
prophecy.
This price drop across all classes of non-Government-issued
assets, has greatly reduce the wealth of US consumers.
The famous “Pigou
Effect”
is that people consume less when they become less wealthy.
This reinforces the price drop as private companies have
less sales and profits. When real output drops, as it
must in the face of the commercial-credit shortage reducing
output and the Pigou Effect reducing demand, there are fewer
good and services being chased by the money supply.
This exacerbates the inflation that any bail out of the
financial crisis will bring, as explained in Section (5.)
below. The combination of factories and farmers not
being able to finance their output and consumers not
spending culminate in widespread retail store closings,
which herald a depression.
(3.) DELEVERAGING, WRITE-DOWNS,
AND DEFLATION
Two important factors that we have not addressed, with
respect to their effect on the money supply, are: (i.)
deleveraging of US dollar debt, i.e., reduction in US-dollar
loans outstanding by banks, and (ii.) writing-down of
US bank assets. Both phenomena are reported worldwide,
and if true, represent dangers to the US economy, which
offset temporarily the inflation dangers of the bailout
described in Subsection (4.2) and (4.3) below.
Existing US-dollar loan balances are reportedly being repaid
faster than the sum of: creation of new loans and the
net increase in the principal of existing loans. As
mentioned in Subsections (2.2) above, many financial assets
are being written down as their market value or perceived
market value falls. In considering these phenomena in
(i.) and (ii.), we will divide US dollar loans to nonbanks
into two classes: lending by nonbank and lending by
banks.
Changes in balances lent by nonbanks do not effect the US
money supply as their issue and repayment occurs by movement
of money between the demand deposits of lenders and
borrowers, thus not changing the total demand deposits
outstanding. However, changes in bank lending does
effect the money supply, as borrowers reduce their demand
deposits to pay off loans. A $1 reduction does not
increase assets of the bank, but rather frees up $0.10 of
their reserves, so that the bank can lend that $1 again.
If the bank does not lend that dollar, then the money supply
is decreased (deflated) by $1. That reduction is not
increased by the money multiplier.
As US banks write down the value of their financial assets,
their bank capital falls. However, US banks must
maintain 8% of assets in bank capital, and these assets (in
the language of bank regulation) include demand deposits.
Bank capital is bank assets minus bank liabilities.
Thus, writing down an asset in the bank capital by $1
reduces the money supply by whatever reduction in lending
occurs, up to a maximum possible reduction (for banks that
were fully lent out with respect to bank capital) of $1/0.08
= $12.50.
These two factors decrease the money supply, and thus offset
money created for the bailout.
However, the Federal Reserve Bank (“Fed”)
reports U.S. bank capital as $1,152.3, $1,207.6, and
$1,191.6 billion on 2 October 2007, 22 October 2008, and 12
November 2008, respectively. Furthermore, demand
deposits of bank and thrifts institutions were $296.5,
$349.8, and $393.6 billion on 15 September 2007, 13 October
2008, and 10 November 2008, respectively. We have not
had a significant decrease in the total bank capital or any
measure of money supply: M1, M2, or MZM. Any deflation
that might occur from reduced bank lending will soon be
swamped by the inflation coming from the bailout as
explained at the end of Section (5) below. This
swamping could be postponed by a huge and sustained rise in
Treasury bond issuance, that would soak up the additional
Treasury bond coupon and principal payments from the bonds
issued to fund the bailout.
(4.) RECCOMMENDED GOVERNMENT ACTION
Government action has to accomplish two tasks. First,
it must immediately stop the general market panic, and
bringing rationality and price discovery to the financial
markets. Second, it must do so in a way that
minimizes the rise of inflation. However, the least
possible inflation in this situation will still be high.
Recommended Treasury Actions:
(A.)
Purchase of preferred stock in U.S. money-center banks and
the principal Treasury
dealers to bolster their balance sheets.
This will help restore counter-party worthiness of the major
financial institutions,
which is a necessary but not sufficient, condition for the
general fixed-income markets
to function.
(B.)
Exchange existing CMO and some CDO instruments (say
“Treasury Blessed
Obligations” or “TBOs”),
that are backed by at least 80% US collateral, from any
holder
for Treasury “warehouse
receipts”.
Make them more attractive and less mysterious
to investors, auction them, and turn over the auction
proceeds to the receipt holders.
(B.1) This is subject to a minimum size of the
TBOs exchanged and of the issue
involved. Require, by law, issuers and servicers of
any TBOs acquired to summit
a report on the title and liens status of TBOs.
(B.2) Where feasible, combine the slices of common TBOs to
reduce complexity.
(B.3) Assign collection of TBO’s underlying debt
over 180 days delinquent to the IRS.
The IRS budget must be increased for this service.
(B.4) Waive all Federal tax (inheritance tax
too) on income from any instrument
eligible to be a TBO. Encourage the states and local
governments to so also.
(B.5) Indemnify any holder of TBO from loss
because of title or lien, with specified
indemnity-payment timing. Treasury should contract out
title and lien checks
before auctioning the TBOs.
(B.6) Contract out TBO analysis, valuation,
history, and the procurement of related
databases (e.g., those of Bear Streans and USATitle) that
will be posted on the
internet. Contract the workout and
collateral-management services for all TBOs
under a unified and consistent system. The Treasury
should pay the cost of
such contracts from an increased budget.
(B.7) Immediately payout the cash stream as
received from the TBOs to the receipt
holders. After acquiring a substantial part of all
U.S. CMO and CDOs, an
auctioning decision should be made: will the
TBOs fetch more as individual
bonds or as a single homogenous issue. A holder of any
such single issue would
receive a share of all TB0’s cash stream. It is a
question of whether complexity
trumps homogeneity in the market. Auction off the TBOs
accordingly.
(C.)
Guarantee the timely repayment of 90% of certain classes of
new private loans to U.S.
borrowers, that meet certain minimum standards. These
classes are those supporting
key areas of the economy, like student, home, and auto
loans. Apply (B.1) through
(B.4) to the loans involved as if they were TBOs.
(D.)
Encourage the Financial Accounting Standards Board to change
FASB 157 for Level III
assets, as well as, CMO, CDOs, and TBOs (whether they are
Level III assets or not).
For each asset independently, the holder should be able to
book its value as the:
(i.) current actual or inferred market price, or (ii.)
present value of the holder’s
intended expected-marginal cash flow attributable to that
asset, using the discount
rate equal to the owner’s opportunity cost of funds and
appropriate risk adjustments.
Recommended Congressional Actions:
(E.)
Congress accommodates (b.) above by amending the Mortgage
Forgiveness Debt Relief
Act of 2007 to waive recognition of ordinary income for all
debt forgiveness on primary
residences only if:
(E.1) borrower obtains consent of any of his
mortgage servicers, any of his mortgage
holders, a bankruptcy court, or
(E.2) demonstrates to the IRS that he or she was
probably the victim of any predatory
lending.
This will remove the incentive to SCICS described in
Subsection (1.1.3) above, except
where it is part of a resolution or untoward lending.
(F.)
To accommodate (b.) above, for tax purposes in the next 10
years, Congress should
mandate that the holder of the asset or liability in (b.)
above has the option to choose
(i.) or (ii.) above or cost basis for each individual asset.
This choice is independent of
such choice for other assets and regardless of the choice of
book value for that asset.
This exchange attenuates a key driver of the credit crisis
as explained in Subsection
(1.2) and the third paragraph of Subsection (2.2) above.
(G.)
Legislate liability for valuations in major financial
markets, including the major over-
the-counter markets and hedge funds. Hold anyone who
is responsible for valuing an
asset or liability in such markets personally liable civilly
and criminally for any
substantial valuation errors attributable to substantial
instances of:
negligence,
conflict of interest, or fraud. This liability is to
anyone or entity who suffers from such
valuation, or who regulates the person responsible. A
valuation that meets the IRS
“substantial authority” or the general “reasonable man”
tests will exempt the valuer.
But, he or she will be responsible for being aware of the
general complexity of the
valuation involved to the extend of standard industry
practice.
Recommended Federal Reserve Actions:
(H.) Allow banks to post TBOs as reserves,
up to some prudent limit.
(I.)
In conjunction with the FDIC, require all U.S. banks to lend
80% of their previous 5-
year average in each major category of lending, as a
condition of maintaining their
banking license and FDIC insurance (with an exception
process for banks in special
circumstances).
(J.)
Pay interest on member bank reserves only up to the minimum
reserve requirement
for the volume of demand deposits the bank has. This
will avoid an additional
disincentive to lend.
Recommended Actions for all the Entities Above
(K.)
Hold a carefully-staged announcement by the President,
Treasury Secretary, Fed
Chairman, and Congressional Leaders. Include any of
their likely successors. It
should be thoroughly researched and planned for maximum
psychological impact on
the financial markets. It is important to do this
before consumer and investor
psychological is further shaken by widespread retail-store
closings.
(5.) SHORT-TERM EFFECTS OF GOVERNMENT ACTION
(5.1) Relation of Money Supply to Fed and Treasury
In this analysis we will use the M1 and M2 definitions of
the money supply. M1 is all the US-issued cash and
coins in circulation and all the US-dollar demand deposits
(checking accounts) in US banks. M2 is M1 plus:
(a.) time deposits, money market mutual-fund shares, money
market deposit accounts, and overnight repurchase agreements
all in the U.S., and (b.) overnight Eurodollar
deposits (U.S.-dollar demand deposits in foreign banks).
If a bailout delivers an amount of money to bond or equity
holders (other than U.S. Government), then, through the
money-multiplier effect, that amount is expanded. The
Fed’s reserve requirements for demand deposits since 20
December 2007 have been 0%, 3%, and 10% for deposits under
$9.3 million, between $9.3 and $43.9 million, and over $43.9
million, respectively.
For time deposits it is 0%. Thus each bail-out dollar
disbursed could theoretically produce up to $10 of new
demand deposits (and infinite dollars of time deposits),
since that dollar becomes an extra dollar of reserves when
it is deposited, that will support up to $10 of new loans.
These loans become new demand deposits and currency.
However, the emergence of sweep time-deposit accounts has
made reserve requirements less of a constraint and less
important, and as a result banks are not lending to their
limit. The M1 money multiplier is the ratio of M1 to
currency and bank reserves, and it has fallen from about 3.1
in 1987 to about 1.2 now. The M2 money multiplier is the
ratio of M2 to currency and bank reserves. It rose
from 5.3 in 1987 to 8.6 in January 2007, and then gradually
fell to 6.9 in October 2008.
When a borrower pays money back to a (nonbank) lender, it:
(a.) decreases the money supply by reducing the borrower’s
checking account, and (b.) increases the money supply
an equal amount by increasing the lender’s checking account.
If the lender is a bank, then the money supply decrease does
not reverse until it is lent out again. In a cash
rescue, the borrowers do not repay and thus do not reduce
their checking accounts, but a nonbank bond holder adds the
government’s rescue payment (money created out of thin air)
to their checking account. The money multiplier acts
on that increase in deposits.
By law the TARP must be funded by the Treasury issuing
additional debt, as it will certainly also do for the its
non-TARP part of the bail. As the Treasury buys assets
from, or invests in (i.e., buys preferred stock from),
financial institutions, there will be a rise in the demand
deposits of those institutions. This rise will equal
the fall in the demand deposits owned by the purchaser’s of
those additional Treasury bonds. Hence, there will be
no immediate rise in the money supply. But it will
rise as those new bonds deliver coupon and principal
payments in the future. More importantly, these
additional Treasury-bond issues will increase the supply of
Treasury debt, and thus lower the value of such debt, i.e.,
raise Treasury interest rates. This in turn will raise
all other US-dollar interest rates and crowd out some
private borrowing. The Fed and the FDIC are also major
players in the bail out, and their rescue payment will be
pure increases in the money supply, unless special
arrangements are made by Congress to fund them via new
Treasury bonds.
How much rates will rise depends on many factors that
determine the elasticity of interest rates with respect to
the supply of Treasury bonds. An important factor is
the extent to which the Fed accommodates the purchases of
Treasury bonds by increasing the money supply. But,
increasing the money supply creates inflation, which raises
interest rates. The Federal Home Loan Bank Board (“FHLBB”)
also borrows money but that does not count in the National
debt.
(5.2) Bail Out’s Effect On The Money Supply
The New York Times Business Section featured “Tracking the
Bailout: The Government’s Commitments” on 25 November 2008.
It reported that the Government bail out total reached:
(i.)
$1.7 trillion
loans by Fed;
(ii.)
3.0 trillion
preferred stock and mortgage purchases by FDIC, Treasury,
and FHLBB ($0.60 trillion);
and
(iii.)
3.1
trillion
debt guarantees by Fed, Treasury, and FDIC.
$7.8 trillion
Total
Assume: no guarantees in (iii.) are ever paid except
the initial $200 billion Treasury guarantee on Freddie Mac
and Fannie Mae losses, which have already occurred;
the loans in (i.) and purchases in (ii.) do not ever
increase from these levels; the bail out is
implemented in 3 years; the current $407 billion/year
rate of annual Government deficit spending (i.e., that of
fiscal year ended 30 September 2008) is unchanged for three
years; and the Fed’s announced $620 billion temporary
reciprocal-currency arrangements (swap lines) with foreign
central banks is unchanged and fully used for three years.
In (i.) and (ii.) the Fed will create $1.71 and $1.60
trillion in new money to lend to financial institutions
against mortgage-backed securities and to buy commercial
paper, respectively. In (ii.) Treasury will borrow
$0.70 trillion to buy preferred stock (under TARP).
Separate from these transactions: Treasury will borrow
$53 billion to purchase of credit default swaps and
residential-mortgage-backed securities from AIG and $1.23
trillion to fund the deficit for three years; and the
Fed will create $20 and $620 billion ($520 used now) in new
money to buy preferred stock from Citigroup and fund the
dollar-swap program.
This leaves us with the creation of $4.06 trillion in new
money and $2.13 trillion in new Treasury borrowing under our
optimistic assumptions. Further assume that this
borrowing will cost a total of 6% in interest payments over
the three years we posit it will take to implement the
bailout. These interest payments will raise the money
supply as bond holders receive them. Then the M1 and
M2 money supplies will expand by $4.06 trillion + (6%
of $2.13) trillion = $4.18 trillion, times the 1.2 M1 and
6.9 M2 money multipliers, which equals $5.02 and $28.86
trillion, respectively.
To put this in perspective, note: M1 and M2 money
supplies are $1.47 and $7.85 trillion (as of 27 October
2008) respectively, U.S. Treasury debt is $10.65 trillion,
and U.S. Gross Domestic Product (“GDP”)
is $14.5 trillion per year.
Ceteris paribus,
M1 and M2 will rise by 242% and 268%, respectively, in three
years.
In the likely absence of significantly higher real output
(i.e., higher GDP), any increase in the money supply created
by the bailout will be chasing the same amount of goods.
This is the demand-pull that spells continued inflation, and
thus the expectation of inflation, both of which raise
interest rates. We have to add to this whatever
increase in money supply that the Fed creates to accommodate
the Treasury bond issues used to fund the bail out.
However, this rise in money supply will be reduced to the
extant that demand deposits are dissipated via the public’s
purchase of still-more Treasury debt. But there are
limits to the market’s appetite for Treasury debt, and a
larger supply will lower the market price, and thus by
definition raise interest rates, distinct from the rise in
interest rates caused by inflation.
(5.3) Trade Off Of Money Supply and Treasury Debt
We contrast the changes in money supplies and in total
Treasury debt computed above in Subsection (5.2), with such
changes if the Treasury soaks up the increased money supply
by issuing still more bonds. Treasury would issue an
additional $4.18 trillion over the assumed three years of
the bailout. Under our assumption above, the Treasury
will payout 6% of that in additional interest over three
years, which creates $251 billion times the money
multipliers, which equals $0.27 and $1.55 trillion more M1
and M2 money, respectively.
Given our optimistic assumptions come true, at the end of
three years we face these two polar sets of changes, or
something proportionally between them, from the bailout in
excess of such changes from other factors:
(a.)
242% and 268% increases in M1 and M2 money supplies,
respectively with a 20.0%
increase in Treasury debt,
(b.)
20.5% and 22.1% increases in M1 and M2 money supplies,
respectively with a
59.3% increase in Treasury debt.
If things turnout worse than we assume for the next three
years, the money supply and Treasury debt will grow even
larger. Important worse outcomes include: more
of the myriad Government guarantees in (iii.) above come
due, more firms are bailed out, the annual deficit grows,
and interest rates rise (3 years of interest totals more
than 6% of new Treasury borrowings).
It is the prospect of these changes that lead to the
suggestion in Section (4.) (B.) above. Any CMO and CDO
purchases that maybe contemplated should be exchanged for
warehouse receipts
instead of money. Note, such purchases are not part of
the current bail out enumerated in (i.), (ii.), and (iii.)
above from Treasury, Fed, or FDIC. But FHBB is buying
MBSs. The receipts approach will avoid any such
purchases raising the money supply even more than suggested
by our calculations here. However, Treasury directly
borrowing (with regular Treasury instruments), instead of
guaranteeing assets or having an agency like FHBB buy them,
will minimize interest expense. The advantage is such
a suggested approach is demonstrated by 30-year Ginnie Mae
bonds (that have a full-faith-and-credit Government
guarantee) trading with 2.6% higher yield than Treasury
bonds in November 2008. Crown corporations like the
Canadian Mortgage and Housing Corporation have illustrated
this point since 1944.
(6.) LONG-TERM EFFECTS OF GOVERNMENT ACTION:
TIPPING POINTS
If the scenario described in Subsection (5.) above
materializes, then the credit markets and world opinion will
expect prolonged inflation in the U.S. This will
likely provoke two successive psychological-tipping points.
These tipping points are similar in some ways to the fear of
a bank failure that becomes a self-fulfilling prophecy, but
are likely to be based on more-realistic fears. The
mere prospect of these tipping points can cause investors to
act before it is justified by economic circumstances, as the
possibility of such action causes a run. This would
cause foreign investors to dump U.S. debt or dollars before
others do, accelerating the run into a self-fulfilling
prophecy just like a run on a bank.
(6.1)
Foreigners Dump U.S.-Dollar-Denominated Debt
Foreigners will stop wanting to hold US dollar-denominated
debt because its value will be expected to dissolve with
high inflation. To not hold such debt, they must sell
it, i.e., exchange it for U.S. bank demand deposits.
This implies debt-instrument prices will fall, which raises
U.S. interest rates by definition. It also leaves
foreigners with far more U.S. dollars than they hold in
equilibrium, which implies that they will sell the dollars
for foreign currency. Thus, the dollar will fall
sharply against foreign currencies. That, in turn,
further increases inflation as imports (like oil) become
more expensive.
(6.2)
Foreigners Dump U.S. Dollars
If the bailout leads to fear of hyperinflation, as suggested
in Subsection (2.2) above, and U.S. dollars are perceived by
foreigners as falling against other currencies long term,
then they will not want to hold US dollars. To stop
holding dollars, foreigners will buy US goods and services
with those dollars. That might seem fine for U.S.
producers, but the US economy will suffer “Seigniorage
Shrinkage". Seigniorage is the profit a
government makes on the money it creates, i.e., the value of
the things it buys with the money it circulates minus the
cost of creating the money.
Seigniorage Shrinkage works as follows. Until now,
foreigners have produced goods and services, which were
consumed in the U.S. and paid for in U.S. dollars which were
created at very low cost. But, the U.S. sends
foreigners less goods, services, and financial assets in
return. The difference is that part of the U.S.
merchandise trade deficit that is held by foreigners as U.S.
dollars (paper money, coins, and U.S. bank demand deposits)
and used as a medium of exchange. This is a temporary
gift from foreigners to U.S. consumers, or more accurately
an open-ended callable loan with a negative interest rate
equal in magnitude to U.S. inflation. If foreigners
switch to other currencies as a medium of exchange, they
will buy U.S. goods and services with U.S. dollars that the
U.S. cannot consume. This reverses the beneficial
seigniorage of the past, which in turn, lowers the U.S.
standard of living.
Foreigner spending US currency and demand deposits in the US
will not increase the US money supply (since they are
already counted in the money supply). But it will
create demand pull on domestic prices, since it will be
chasing US goods and services instead of facilitating
foreigner-to-foreigner transactions.
Note, much of this foreign-circulating U.S. currency is
paper money and coins (rather than demand deposits).
The Fed estimates about $778 billion of currency is in
circulation, but does not have an accurate measure of this.
About 90% of all $100 bills printed are sent to the New York
Federal Reserve bank for shipment overseas. Several
academic studies by the Federal Reserve Board of Governors
and by private economic policy research institutes like The
National Center for Policy Analysis in Washington, DC,
estimate foreign circulation of paper money and coins at
between 40% to 60% of the total. Whatever proportion
of that being spent in the U.S would increase the money
supply by 20% to 30% of that proportion.
(7.) CONCLUSION
The U.S. is facing a classic economic slowdown, which is
based entirely on investor, employee, and consumer
expectations that there will be a severe slowdown.
Such slowdowns are self-accelerating and self-fulfilling,
and can only be diverted from their natural and disastrous
course by the widespread expectation of decisive Government
action. In particular, the Government should make a
single dramatic presentation which convinces the American
people that more-than-sufficient actions will be taken by
all the relevant parts of Government, working in unison.
This must be done before the next obvious harbinger of
depression becomes apparent: the mass closing of
retail stores across the country. Such closings may
occur in the second quarter of 2009. The actions
recommended in Section (4.), and perhaps others, should be
woven into a carefully staged and researched presentation to
the public. As much effort should be committed to that
presentation as to the actions. The presidential
inauguration is one opportunity for creating this
psychological turning point for investors, employees, and
consumers. It is this turning point that will solve
the crisis.
The Dangers of Printing Too Much Money
Jaime Cuevas Dermody,
Principal
Financial Engineering LLC
1855 Lake Drive, Delray Beach, FL 33444
561 278-4100
jaime@fe.net
There are many reasons that
the entire yield curve will rise substantially from its
current historically low levels to double digits in the next
three years. This is a real possibility. I
briefly outline here some root causes, implications for such
a rise, and methods of protection, as I see them.
(1.)
ROOT CAUSES of HIGHER FUTURE
INTEREST RATES
(1.1)
Demand-Pull Inflation
(1.1.1.)
Government Policy
The Federal Reserve Chairman, Ben Bernanke, has long
espoused the virtues of protecting real output. He
sees preventing market failure in credit, as a key to that.
Factories and farms need credit markets to finance their
work-in-process inventory and crops, respectively.
This has led him to favor bail outs of large financial
institutions, whose collapse may lead to a crises of
confidence and market failure.
(1.1.2) Government Actions
Each of the actions currently being taken or contemplated by
the Federal Reserve Board of Governors, US Treasury,
Comptroller of the Currency, etc., to rescue or stabilize
financial institutions will create money. Note that
such bail out is likely to take the form of: (i.)
lending money on various nontraditional assets (like CMOs
and CDOs) as collateral, (ii.) buying warrants on up
just under 80% of the borrowers equity (since 80% or more
requires consolidation of the rescuee’s balance sheets into
the US Treasury balance sheet), and (iii.) relaxing
regulatory requirements, that make is easier to meet bank
reserve requirements.
(1.1.3) Effects of Government Action
If the bale out delivers money to bond holders, then it
expands the money-multiplier effect, the supply of money.
The Federal Reserve’s deposit-reserve requirement is 0%, 3%,
and 10% for deposits under $9.3 Million, between $9.3 and
$43.9 Million, and over $43.9 Million, respectively.
Thus each dollar of bail out could theoretically produce $10
of new money. However, banks have not been lending to
the limit of their reserves, so we have a lower realized
multiplier effect. If the Government chooses to
implement the bailout by substituting current bonds for
government-back bonds, then it will not change the money
supply now. However, when the bond coupon and maturity
payment are made, the money will be increased.
In the likely absence of proportionally-higher real output,
such bail outs mean more money is chasing the same amount of
goods. That is the demand-pull that spells continued
inflation, and thus the expectation of inflation, both of
which raise interest rates. Since, we know neither the
extent of such bail outs to come nor the maturity of the
government instruments involved (from immediate cash to
30-year bonds) , it is hard to quantify the amount and
timing of inflation that will be created.
(1.1.4)
Housing Debt
However, if house prices continue to fall in most sections
of the US (as is likely for the rest of the year in the face
of a housing glut), it is very likely that several major
lenders, especially those with leveraged exposure to
home-mortgage credit, will require some sort of bail out,
e.g., Freddie Mac, Fanny
Mae, Countrywide, AIG, and GMAC. This could require
$200 Billion in new money supply added to our approximate
$1.4 Trillion M1 money supply. That reducing the
purchasing power of each US dollar by about 1/7.
(1.1.5)
Level III Assets
All this is acerbated by the Level III assets held by these
financial institutions (some of which are collateralized by
housing) and the major Wall Street investment banks.
Examples of the ratios in Billion of dollars of Level III
assets to equity are: Citigroup ratio 1.05 =
$135/$128; Goldman ratio 1.85 = $72/$39; Morgan
Stanley ratio 2.51 = $88/$35; Bear Stearns ratio 1.54
= $20/$13 billion; and Merrill Lynch ratio 0.38 =
$16/$42.
Level I assets are ones for which there is a liquid market
price available, Level II assets are those that can be
valued by a close proxy asset and a no-arbitrage argument,
and Level III assets are those for which neither is
available. The latter require complex mathematical
models and many assumptions. At best the heads of the
proprietary desks that own these assets have some insight
into their true value. In particular, internal and
external auditors are generally clueless about their value
and rating agencies have grossly overrated them. As if
that were not bad enough, those desk heads are responsible
for marking their Level III assets to market each day, but
are paid bonuses based on how much the Level III assets rise
each year. It is quite possible that every major Wall
Street investment bank, that has substantial Level III
assets and high leverage, is bankrupt. In some sense,
the actions of the US Treasury and the Federal Reserve may
be aimed at avoiding this becoming obvious to the markets.
(1.2) PSYCHOLOGICAL TIPPING POINTS
A some point in time during a prolonged period of inflation
in the US, there may come two successive
psychological-tipping points.
(1.2.1) Foreigners will stop wanting to hold US
dollar-denominated (noncash) assets. To not hold that debt,
they must sell it, which implies debt-instrument prices will
fall, which means interest rates will rise further.
(1.2.2) If inflation persists (aggravated by such
debt-instrument selling),
foreigners will not want to use US dollars as a medium of
exchange, To stop holding it, they will buy US goods
and services. That might seem fine for US producers,
but the will buy US goods and services. That might
seem fine for US producers, but the government makes on the
money it creates, i.e., the value of the things it buys with
money that it prints (most is created electronically) minus
the cost of creating the money. Until now, foreigners
have produced goods and services, which were consumed in the
US and paid for mostly with electronic money (created at
virtually no cost) This part of our foreign purchases was,
in effect, a gift from foreigners to us, as we consumed
their goods and service, but sent them no goods and services
in return.If they switch to another currency, as a medium of
exchange, they will buy our output of goods and services.
These
previously foreign-circulating dollars will add to the
demand pull on domestic prices. Thus, even more money
will chase US goods and services, causing even more
inflation. Furthermore, we will sell our goods and services
in exchange for this electronic money,
which
we cannot consume. This reverses the beneficial
seigniorage growth of the past, which in turn, lowers our
standard of living.
The extent of this demand-pull inflation depends on how many
financial institutions are bailed out and the amount of
money created for each. To the extent that the
government just changes standards and
ignores
problems until they get better, there will not be as much
inflation.
(1.3)
Cost-Push Inflation from Oil
In the next few months, the amount of oil consumed and the
amount produced is unlikely to change significantly.
In that period we will not see
much of
people moving closer to work, replacing large cars with
small, installing new rail lines, bringing new oil fields on
line, and substituting other sources of energy for oil.
Thus, the demand curve and the supply curve of oil are
coincident vertical lines (in a graph with oil price on the
horizontal axis and oil volume on the vertical axis).
There is no neoclassical unique price and volume here at
which a downward-sloping demand curve crosses an
upward-sloping supply curve. Any price in a large
range is an equilibrium in this short run. The
particular market price extant has more to do with
psychology than economics. News shocks send the oil
futures market up and the spot price follows it through
their linkage between those markets.
However, consumers are responding in the longer run and this
is reducing demand for oil. If prices stay high, more
new oil will be sought and sources of oil that were
previously restricted politically are more likely to be
exploited. Some of this reduced oil consumption and
reduced oil use in production will decrease the output of
goods and service, but the former may increase savings, and
thus investment. Overall it is likely to reduce the
overall output of goods and services, which in itself will
raise inflation. This effect could be negated by the
Federal Reserve reducing the money supply, but that has been
rare historically.
Over longer time periods the supply and demand curves become
less steep, and relatively small reductions in demand and
increases in supply have a large effect on price. The
unusually-large number of new players, with long futures
positions in oil, and this price sensitivity make that
market susceptible to a crash on news that implies oil
prices will fall. The current run up to $135/barrel
oil is likely to
be burst bubble in
a few months, absent any significant reduction in supply.
That bursting would in turn reduce inflation.
Since oil is important for production and consumption, its
40% price rise in the last year increases average prices.
This adds another dimension to rising inflation, and more
fear of inflation that itself causes more inflation.
All of
this is likely to contribute another
1% to 2% percent to total inflation this year.
(1.4)
Cost-Push Inflation from US Government Spending
Any domestic policy changes or international crises, that
raises US government spending, unaccompanied by immediate
tax increases, will send yet more dollars chasing the same
amount of goods. This provides yet another source of
inflation. In particular, US government borrowing
crowds out some private borrowers and raises interest rates.
(2.)
EFFECTS of HIGHER INTEREST RATES
(2.1)
Higher interest rates will reduce the present value of many
assets, as their future cash stream will be discounted in
the market by these higher rates.
(2.2)
These affected assets include those which provide services
or cash in the future, like real estate, insurance, equity
stocks, and most long-term bonds. For many investors
and some consumers (those purchasing long-term services,
e.g., owning real estate is buying an infinite-life stream
of rental services), much higher interest rates will greatly
reduce their wealth. That is, for many
assets, higher interest
rates will discount future cash streams more than it will
increase the size of those streams.
This effect is exacerbated by the reduced effective demand
for such assets caused by more-expensive and less-available
lending. It is moderated a little by people fleeing
financial assets for tangible assets, in particular
commodities, like gold.
(2.3)
Apart from such adverse wealth effects, the object of many
people's wealth is consumption (including charity), which
will be separately affected by high interest rates.
Simplistically, interest rates are the sum of real-economic
growth and inflation. Very-high interest rates are
mostly inflation. As I recall in August 1981, the
18.79% 3-month Libor was associated with negative real
growth and in the neighborhood of 20% inflation.
Consumption is reduced proportionally by inflation, e.g.,
20% inflation reduces real consumption per dollar by 1/5 per
year.
(3.) PROTECTION AGAINST
HIGHER INTEREST RATES
(3.1)
Substantial investors can access the fixed-income market, to
hedge the above-mentioned dangers.
Several factors have depressed the price of fixed-income
volatility compared to historic levels, and this has made
interest-rate hedging inexpensive in comparison to 10 years
ago.
(3.2)
For many entities it is important to hedge against the
effects of interest rates on their solvency over the long
term, e.g., 30 years. However, most entities do
not consider hedging beyond specific variable-rate loans.
A fixed-rate loan in place of the variable-rate loan at risk
is the obvious and less-costly solution. Many
different types of entities are vulnerable to high interest
rates. If rates are very high, like the 18.79% 3-month
Libor in August 1981, then: (i.) real-estate
developers have no profitable projects to engage in,
(ii.) hedge-fund managers have difficulty charging 2% and
20% when CDs offer 16%,
(iii.) retailers of discretionary luxury and consumer goods
find sales plummeting, and (iv.) charities receive
fewer contributions.
Consider for example the plight of a particularly-vulnerable
business, Home Shopping Club: almost all their sales
are by credit cards, the average US household has $7,000 of
credit card debt, rising at $1,000/year, and short-term
rates are near historic lows. If rates rise to near
1981 levels, its sales are like to dry up, leaving that firm
with nothing but very-fixed cost.
(3.3)
However, few financial services firms are disposed
to offer this service. To buy such protection
efficiently requires access to mathematical-finance
expertise and relationships with fixed-income
trading desks
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Financial Crisis, Deleveraging,
Hyperinflation & Policy page
1
of
23
10 January 2008
The Financial Crisis: why, where it is going
& how to fix it
Jaime Cuevas Dermody, Principal 10 January
2009
Financial Engineering LLC, 1855 Lake Drive,
Delray Beach, FL 33444 561 278-4100 jaime@fe.net
(0.) PREAMBLE
This paper was originally prepared for a
talk on “The Dangers of Printing Too Much Money”.
It was given on 17 June 2008 to the
Investment Management Institute Conference at the
Avenue Hotel in Chicago. In that talk, I
said that every major Wall Street investment bank
was bankrupt, or in grave danger of it, for
the reasons given in Subsection (2.3) below.
Many in the audience since apologized for
ridiculing that remark and suggested making the
talk into a paper updated for recent events.
In doing so, I have focused on the legal and
regulatory environment that precipitated the
financial crisis, the “market failure” in the
CDO (collateralized debt obligation) market
that sparked the crisis, its spread into a general
credit crisis, the consequences of the bail
out of financial institution, and Government actions
that can alleviate the crisis.
Section 1 is a history of the current
financial crisis, in particular its regulatory, legal, and
policy foundation. Sections (2.) and (3.)
explain the mechanics of how the CDO crisis began
and spread to a general financial crisis.
Section (4.) points out important side effects of the
crisis, including home-collateral
destruction and the bailout inducing greater risk taking at
rescued firms. Section (5.) discusses the
reduction in loans outstanding from money-center
banks (deleveraging).
Section (6.) makes 10 recommendations for Government Action.
First, is 9 specific policy actions. Second,
is one recommendation on the announcement of
the first nine actions, in order to obtain
an effective psychological impact on the markets.
The latter is as crucial as the former,
because it must restore both investor confidence in
those institutions and consumer confidence
in continued employment. Without that confidence,
the economy will not recover. Sections (7.)
and (8.) discuss the short-term and longterm
consequences, respectively, of the current
Government bail outs, and in particular of
two polar cases of financing it. This
analysis suggests we will face 10% to 20% short-term
Libor rates one to three years from now.
Section (9.) is a brief conclusion, that warns that
the recommended actions are needed before
investors and consumers are further panicked
by the specter of massive retail-store
closings and home-collateral deterioration, which is
likely to worsen in the first and second
halves, respectively, of 2009.
(1.) WHY
(1.1) Regulatory and Legal Precursors of the
Crisis
Bad regulatory and legal changes occurred in
the 1970s and 1980s. Milestones include:
1975 Securities and Exchange Commission
(“SEC”) Rule 15c3-1 uses the ratings of
“nationally recognized statistical rating
organizations”1
(“NRSRO”)
for broker-dealer
net capital requirements. Over the next
decade, “The
SEC and other regulators effec
tively ceded to CROs their public-interest
responsibilities for monitoring and disclosing
investor loss exposure in structured
financial instruments.”.2
1
The SEC designated
credit rating organizations (“CROs”) as NRSRO through
‘no-action” letters in response to requests
by security issuers. In 2006, The Credit
Rating Agency Reform Act (PL 109-291) required the SEC to
set up a formal
process for NRSRO designation but not
regulation. In 2007 the SEC did that.
2
Caprio, G. Jr.
(Williams College), Demirguc-Kunt, A. (World Bank), and
Kane, E.J. (Boston College & NBER). “The
2007 Meltdown in Structured Securitization:
....”. Working Paper. 5 September 2008. CRO means credit
rating organization,
which includes the NRSROs.
Financial Crisis, Deleveraging,
Hyperinflation & Policy page
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23
10 January 2008
1982 SEC begins requiring less disclosure3
for
issuance of securities rated in the highest
four rating categories of at least one
NRSRO, e.g., at least BBB from Standard &
Poors (“S&P:) or Baa3 from Moody’s Investor
Service (“Moodys”). It also shielded the
NRSROs from liability.4
In 1992 it
amends Rule 3a-7 to exempt from registration
asset-backed securities that are in such
categories (57 FR 56256, Nov. 27, 1992).
1984 The Secondary Mortgage Market
Enhancement Act (Public Law 98-440) eases issuance
requirements of asset-backed securities that
are a “mortgage related security”,
which it defines as one in the highest two
rating categories of at least one NRSRO
(e.g., at least Standard and Poors AA or
Moody’s Aa3).
1987 Federal Reserve Bank (“Fed”) expanded
its use of NRCRO ratings beyond requirements
for bank-portfolio (of marketable
securities) to prudential rules of bank supervision.
5
It defined “externally
rated” in Code of Federal Regulations Title 12 Part 325
Subpart B Appendix A (6.). That year, its
Regulation T set the above-mentioned
highest two categories as the standard for
margin lending on securities.
1988 The international Basel I Accord is
established with simplistic risk-weight ing of assets
classes, and the major commercial banks
react by: arbitraging this weighting to
leverage their capital, and seeking the most
profitable regulatory home around the
world for each aspect of their operations.
1988 The first structured investment vehicle
(“SIV”) is created by Citibank to take advantage
of the above, and dozens of other SIVs
follow. SIVs issued short-term commercial
paper and mid-term notes to fund the
purchase of much-longer-maturity CDOs,
all off balance sheet. Some SIVs were funded
instead by issuing tranches of their
CDOs. Many hedge funds leveraged purchases
of CDO with lines of credit.
1989 Department of Labor issues Prohibited
Transaction Exemption 89-88 (54 FR 42582,
17 October 1989) to ERISA, that allows
pension funds to invest in asset-backed securities
rated in the above-mentioned highest two
categories.
Financial Institutions Reform, Recovery and
Enforcement Act of 1989 bans thrifts
from buying bonds that are not in the
above-mentioned highest four categories (PL
101-73 103 Stat.183, 12 U.S.C. 3331-3351, 9
August 1989).
1991 SEC amends Rule 2a-7 to require money
market funds to hold 95%, instead of 0%, of
assets in the highest short-term rating
category of a NRSRO or in unrated assets of
comparable quality. For S&P it is A-1 and
for Moody’s it is P-1. See Investment
Company Act Release No. 18005, 56 FR 8113,
27 February 1991.
2000 Department of Housing and Urban
Development issued regulations for Freddie Mac
and Fannie Mae, that significantly raised
goals (with penalties for not reaching them)
on their purchase of residential mortgage to
low-income households from 2001 to
2004. No one seems to have dissented.6
These and similar events are explained in
detail in the three insightful articles cited in footnotes
2, 5, and 11.
3
SEC Securities Act
Release No. 33-6383, 47 FR 11466, 16 March 1982.
4
Rule 436 {47 FR
1141, as amended 58 FR 62030, 23 November 1993] deems NRSRO
ratings in a prospectus as not part
of that prospectus for purpose of Section 7
and 11 of the Securities and Exchange Act, thus shielding
NRSROs from expertwitness
liability and the negligent standard of
care.
5
Cantor, R. and
Packer, F. “The Credit Rating Industry” Federal Reserve Bank
of New York Quarterly Review, summerfall
1994.
6
HUD’s Reglations of
Fannie Mae and Freddie Mac: Final Rule, 31 October 2000, 65
FR 65044-65229.
Financial Crisis, Deleveraging,
Hyperinflation & Policy page
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23
10 January 2008
(1.2) House Price Bubble: February 1997 to
July 2006
The housing and credit bubbles, that
precipitated the financial crisis, was a perfect storm
born in the confluence of:
(a.) Commercial and investment banks' and
mortgage originator’s well-developed and ingenious
exploitation of those unfortunate
milestones,
(b.) NRSRO’s manipulation of their rating
standards and mathematical models to maximize
fees for both advising security issuers and
rating their issues,
(c.) Expansion of land use restrictions
(that have been growing in area like Providence RI,
Boston MA, Monmouth NJ, Philadelphia,
Seattle WA, and San Francisco since 1970)
accounted for about 20% of the house price
rise from 1987 to 2006.7
Construction
costs from 2000 to 2008 have risen an
average of 4.8%/year compounded.8
(d.) A general and steep fall in interest
rates from late 2000 to mid 2004,9
(e.) Rising incomes in a robust economy
(except for March to November 2001),
(f.) Maturing of economically more-efficient
financial conduits between ultimate lender
and ultimate borrower,
(g.) 2007 change in US tax law and in
accounting standards, and
(h.) Almost completely ineffective Fed, SEC,
OHFEO, FDIC, and FINRA oversight.10
Millions of people, for the first time in
their lives, qualified for home mortgages, and most
others could quality for much larger
mortgages and more credit in general than was previously
possible. Investment and commercial banks
sought all manner of loans to securitize
and market as a CDO, as long as most of that
CDO could be highly rated by an NRCRO.
They did this to maximize fees and minimize
both their capital engaged and liability for bad
loans, under their windfall of regulatory
changes and oversight. NRCROs developed evermore
clever statistical arguments to justify AAA
and AA ratings for ever-larger parts of CDO
cash streams, including CDOs backed by
subprime loans. Before securitization, originators
carefully scrutinized loans because they
usually kept them and lived with the consequences
of any defaults, all under the direct
scrutiny of bank regulators. Now the bank regulators
and the SEC entrusted the regulatory keys to
the NRCROs, who used them to make record
profits in parallel with the originators,
and the securitizers (who usually were commercial
and investment banks), and the marketers who
sold the securitized bonds.
In particular, home mortgages were pooled
into mortgage-backed securities (MBS), that
were repackaged into CMOs (collateralized
mortgage obligations). A CMO is a set of bonds
that are each the rights to a part of the
entire MBS cash stream. It is one of many types of
7
See the second
paragraph of Section 5 of this remarkable article. Eisher,
Theo S. “House Prices and Land Use Regulations:
A Study of 250 Major US Cities”. Working
Paper Version 2 May 2008. Forthcoming
Northwest
Journal of Business
and Economics.
http://depts.washington.edu/teclass/landuse/
8
The Turner Building
Cost Index measure the cost of building construction in the
US (excluding land). This index is computed
by the Turner Construction Company from
labor rates and productivity, material prices, and the
competitive condition
of the marketplace nationwide. It is widely
used by the construction industry and by Federal and State
governments.
The Turner Construction Company is one of
the largest construction management firms in the world.
9
Many adjustable-rate
mortgages were indexed on 1-month Libor, which fell from
6.827% in November 2000 to 1.007%
in April 2004, rose to 5.4975% in August
2007 and fell to 1.621 in November 2008.
10
Last four are:
Office of Federal Housing Enterprise Oversight (independent
regulator of Freddie Mac and Fannie Mae
from inside HUD), Federal Deposit Insurance
Corporation, and Financial Industry Regulatory Authority
(Non-government
organization formed from oversight
departments of NASD and NYSE in 2007. The latter regulates
their members and broker-
dealers and those of most US stock
exchanges).
Financial Crisis, Deleveraging,
Hyperinflation & Policy page
4
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23
10 January 2008
CDO. The resulting surge of easy credit
fueled effective demand for consumer durables and
houses that: raised house prices 86.4% from
November 2000 to July 2006 (64.2% adjusted
for inflation); caused an increased in home
and consumer durable production, and thus
raised GDP (gross domestic product = value
of all goods and services produced in the US).
This house price rise had several pernicious
effects. It embolden home borrowers, lenders,
securitizers, and CDO salespeople. In
particular, it lead amateur speculators (“flippers”), to
borrow more often and larger, which bid up
house prices still further, and worst of all, both
masked and rewarded rushed, careless, and
occasionally fraudulent lending. Some of these
mortgages were home-equity lines that
further fueled the surge in consumer-durables.
Such careless practices were epitomized by:
three investment banks, namely Bear Stearns,
Lehman Brothers, and Merrill Lynch, as well
as, a prominent home-mortgage originator,
New Century Financial Corp. (formerly NYSE
NEW, now Pink-sheet NEWXQ). The 2007
Fortune Magazine Corporate Rankings for
these firms were 138, 47, 22, and 700, respectively.
On 1 January 2007, New Century was the
second-largest US subprime homemortgage
originator, with 7,200 full-time staff and a
$1.75 billion market capitalization. It
filed for bankruptcy on 2 April 2007. On 16
March 2008, Bear Sterns and JP Morgan announced
a merger, that saved the latter from
bankruptcy. On 15 September 2008, Lehman
Brothers filed for bankruptcy, and Bank of
America announced it would acquire of Merrill
Lynch, which saved the latter from
bankruptcy. The Fed and Treasury accommodated and
subsidized the merger and the acquisition.
In this late-2000-to-early-2007 heyday of
securitization, the major commercial and investment
banks continually improved their regulatory
arbitrage. They devised ever-more efficient
ways of minimizing the capital used and
maximizing the fees earned. This was possible
because of the ever-growing demand for
highly-rated CDOs, that in turn was fueled by
the regulatory and legal changes, like
milestones (i.) through (iv.) above. Caprio
et al
point
out the SEC’s and Fed’s role in creating
this demand: “On the demand side, the SEC and
bank regulators set rules that fed a huge
demand, by trusteed investors, for investment
grade and other highly-rated debt.”1
These banks
partnered with vast networks of sales
forces that originated loans and others that
placed the securitized bonds. These securitizations
were done nominally off their balance sheets
(under Basil I) in league with NRCROs,
which had strong profit incentives to
overrate securitizations. The entire process proceeded
under the blessing of, but with little or no
scrutiny from, the SEC and bank regulators. The
leverage, risk, and complexity of the
securities those banks sold and held rose dramatically.
All this is chronicled in two recent papers,
which provide good explanations of the regulatory,
legal, and policy origins of the financial
crisis.1,11
Hence, CDO volumes soared and their true
average quality plummeted. In 2001 $330 billion
of new subprime, Alt-A, and home-equity-line
residential mortgages were issued, which
was 15% of all new mortgages on US
residences. In 2004, it grew to $1.1 trillion and 37%,
and peaked in 2006 at $1.4 trillion and 48%.12
From 1995
to 2005, mortgage-backed security
(MBS) pools, that were collateralized by
subprime home mortgages (excludes Alt-A and
equity line), grew from $18.5 to $507.9
billion.13
The S&P
Case/Shiller 10-city Composite
Index was 75.43 at the start of the bubble
in February 1997 and peaked in June 2006 at
226.29. This was a 12.61%/year compound
increase. Inflation averaged about
2.21%/year compounded in that period. Hence,
house prices (adjusted for inflation) rose
11
A Congressional
Research Service Report for Congress by Getter, D. E.,
Jickling, M., Labonte, M., and Murphy, E.V.
“Financial Crisis? The Liquidity Crunch of
August 2007”, 21 September 2007. Order Code RL34182.
12
Inside Mortgage
Finance, 2007 Mortgage Statistical Annual, vol. 1, p. 3.
13
These MBS are used
to create mortgage-backed bond, pass-through securities,
CMOs, real estate mortgage investment
conduits, and stripped MBS. See footnote 2.
CMO stands for collateralized mortgage obligation, which is
the set bonds
that are the rights to the cash stream from
MBS.
Financial Crisis, Deleveraging,
Hyperinflation & Policy page
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10 January 2008
10.31%/year on average in the bubble.14
(1.3) House Price Bubble Burst
The US house bubble peaked in July 2006 and
home prices fell nationwide 21.77% by September
2008.15
So many
home-mortgages defaulted by March 2007 that the (often
circuitous)
pass-through payments to CMO and CDO holders
fell notably. The first prominent
CDO failures started with 90% and 100%
deficiencies, respectively, in monthly cash flow to
two Bear Stearns hedge funds16.
These funds held leveraged subprime CDO positions, and
in June 2007 began to close.
This spread panic into the rest of the CDO
market in less than a month, other credit markets
worldwide, and all the other financial
markets by September 2008. Investor panic depressed
many asset prices to irrational levels, and
mark-to-market accounting rules17
then
forced hedge funds and investment-bank
proprietary traders to show losses, even on assets
with steady cash flows, good collateral, and
miniscule defaults. That led investors to withdraw
equity and loans to such funds and traders,
and in some cases led counterparties to
stop trading with them. Hence, the very
people who could bring price discovery and rationality
to the market were sidelined. Their absence
unbridled the irrational fall in prices and
thus exacerbated investor panic. Eventually
the investors holding the MBS and CDOs, who
foolishly trusted the regulators and their
proxies, the NRCROs, lost far more money than
the NRCRO, originators, and bankers made,
and created the current financial crisis.
The financial crisis is having several
negative side effects, that will in turn, exacerbate the
crisis. The most important of these is the
destruction of mortgage collateral value. We are
facing a repeat of the home-collateral loss
from the 1980’s saving & loan crisis, on a vastly
larger scale, as explain in Section (4.)
below. Another effect is that the Government owing
almost 80% of firms like AIG has made the
management much less risk averse. Since receiving
a $150 billion bailout they are risking
mostly the Government’s money. AIG is now
taking enormous risk by selling commercial
insurance at half the price of their competitors.
The essence of the financial crisis is the
lack of investor confidence and trust in financial
institutions and the information they
provide. These institutions include fund managers,
investment advisors, legal and accountant
firms, rating agencies, credit-enhancement providers,
commercial and investment banks, as well as,
Government regulators and officials.
The panicked-investment climate led
investors to shun assets not guaranteed by governments,
and employees to lose confidence in their
future employment. The former sent the
prices of such non-guaranteed assets
plummeting, and the latter triggered a fall in consumption.
Thus, businesses have had difficulty in both
financing their production and in
selling it. These two behaviors feed on each
other and started the recent spiral of lower asset
prices, output, employment, and store
closings.
(2.) THE SPARK: “MARKET FAILURE” IN CDOs
Market failure is the economic condition
defined by a free market not achieving efficient al-
14
We use the S&P
Case/Shiller Index Compoiste 10-City Index CSXR because the
OFHEO index has probems and the
20-city index was not computed before 2000.
15
June 2006 to
September 2008 Composite 20 values of the S&P/Case-Shiller
Home Price Index.
16
Two Cayman Island
funds: Bear Stearns High-Grade Structure Credit Strategies
Master Fund Ltd. and Bear Stearns
High-Grade Structure Credit Strategies
Enhanced Leverage Master Fund Ltd.
17
Rules that require
assets to be valued (‘marked”) on balance sheets (daily in
many cases) at the price at which it is
traded, or in the absence of an observable
price, at a theoretical equivalent value. Each such price
change is an income
event.
Financial Crisis, Deleveraging,
Hyperinflation & Policy page
6
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10 January 2008
location of scarce resources. This efficient
allocation is known to economists as a “Paretooptimal
allocation”, and is defined as an allocation
for which no reallocation can make any
market participant better off without making
another worse off. It is equivalent to achieving
a price equilibrium, in which everyone is
holding the set of assets they want, given the market
prices and their budget constraint.
Theoretically, in such an allocation, investors who
are willing and able to pay the most for a
given asset, like a CDO, are left holding it.
This definition of market failure is vague.
Some economists and commentators describe a
market as suffering from market failure,
when in fact that market merely has significant
transaction costs that are overlooked and
cause suboptimal allocation. The current markets
for CDOs, and Level III assets in general,
suffer from three important transaction costs
that, in part, explain the lack of trading
and therefore of apparent market failure. I will label
these types of transaction costs: asset
complexity, valuation complexity, and propertyright
complexity. These transaction costs are
explained in Subsection (2.1) and their effects
on the financial markets are described in
Subsection (2.2) and Section (3.) below.
(2.1) TRANSACTION COSTS
While these explanation of transaction costs
may seem tedious, they are crucial for grasping
the mechanics of the market failure that
started the financial crisis. To understand the effects
of these transaction costs on those markets,
let us start from the simple and obvious
premise that any particular asset is valued
by an investor based on his or her expectations
of that asset’s future cash stream.
(2.1.1) Asset-Complexity Transaction Cost
Many of these debt instruments, like CDOs,
have complex cash flows by their very nature.
A CDO is the right to the repayments of
thousands of loans (that last up to 30 years), net of
the collection costs (e.g. the servicing of
the performing loans and the workout, collateral
foreclosure and/or maintenance costs of
nonperforming loans). The most complex type of
CDO is a collateralized mortgage obligation
(“CMO”), which is a set of bonds that are the
rights to various parts of a mortgage backed
security (“MBS”). An MBS is a pool of home
mortgages, each of which allows the borrower
to prepay any part or all of the mortgage
without penalty.18
To value a CDO cash stream, one must form a
probability distribution over the future behavior
of thousands of borrowers, whose loans are
part of a single CDO. This behavior is
affected by several primary factors,
including collateral values and borrowers’ ability and
willingness to make their payments. These
primary factors, in turn, depend on future
changes in secondary factors: (a.)
employment rates and geography, (b.) interest rates,
(c.) replacement costs of collateral, and
(d.) taxes. These factors change both the CDO cash
streams, via their relation to the
propensity for prepayment and default, as well as, the
economic
impact of such on the CDO holders, e.g., the
reinvestment rate for prepaid principal.
For CMOs, add the contagious loss in
collateral value from home abandonment. This creates
intricate feedback loops that are difficult
to predict.
The models used to value CDOs, backed by
home MBS, assumed that delinquent home
loans would be well managed for the benefit
of CMO holders. This involved workout or orderly
foreclosure and resale of the homes. But the
sheer volume of delinquent home mortgages
since 2006 has overwhelmed the ability of
bankers and mortgage servicers to cope.
This has greatly reduced collateral value
and lead to a contagion of foreclosures. In general,
bankers and servicers are not able to
efficiently deal with the delinquencies and collateral.
18
This right is an
American call option (which the lender in effect sold the
borrower) on the mortgage, that is embedded in
the mortgage and paid for with a higher
interest rate than would otherwise be the case.
Financial Crisis, Deleveraging,
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10 January 2008
The highly-heterogeneous nature of CDOs is
another part of this complexity. Just in the
CMO variant of CDOs, there are many basic
types of home loans, often in the same CMO:
fixed rate, floating rate, hybrid (part
fixed and float), low “teaser” fixed rate turning to higher
fixed or floating rate, non-amortizing
balloon payment loans, graduated payment, negative
amortizing, “no documentation”, and
“no-income verification”. This heterogeneity continues
with the different homes that are mortgaged
and the particular circumstances of those
mortgages, including quality of the
documentation involved, local real-estate markets, the
income and economic circumstances of the
borrower, and state laws, etc. This complexity
is sometimes exacerbated by the partition of
the CMO into many different bonds. Some of
this partitioning creates additional risk,
as in principal-only and interest-only bonds. When
part or all of a CMO is paid off early, any
principal-only bond holder is helped by earlier repayment
of principal, undiminished for the time
value of money, whereas the interest-only
bond holder is hurt by losing their payments
for that part of the loan.
Hence, it is difficult for CDO investors to
understand both the mechanics of the promised
cash stream and a probability distribution
over that stream. I recently reviewed a 15-page
bid on valuing the bonds from a CMO. The bid
was $240,000 to construct a model of the
cash flow, and $64,000/month to maintain it.
All of this increases the risk and cost of
trading CDOs, to an even greater degree than
the heterogeneity of the municipal and corporate
bonds does in those markets. It also makes
investors more leery of coping with CDOs
when their value changes in unexpected ways,
because it is so difficult to appreciate their
circumstances or to evaluate alternative
strategies, e.g., holding, selling, or hedging.
(2.1.2) Valuation−Complexity
Transaction Cost
A fundamental task of accounting is to
assign a useful value to an asset. In November
2007, the Financial Accounting Standards
Board’s issued Statement of Financial Accounting
Standard (SFAS) 157. It required many firms
to mark to market financial assets. The
lack of a liquid CDO market has made this
difficult and led to a disparity of values among
holders of the same instrument. The
theoretical foundation of SFAS 157 is problematic.
The value of an asset to a firm depends in
part on how it intends, and how it is able, to
make use of that asset. In many cases, a
firm intends to sell the asset and cannot make
economic use of it in any other way.
Consider a medical supply firm owning an X-ray machine,
with no ability to use it for anything but
selling it. In contrast, a radiologist can use
it either as a diagnostic tool, and thus
earn a stream of marginal revenue from it, or sell it.
Suppose the medical supply house can
profitably sell it for $10,000 with $1,000 of additional
marketing costs, and the radiologist can use
it to increase the present value of his or
her cash flow by $20,000. Further suppose
there is a tax credit on the machine for doctors,
but not suppliers, worth $1,000 in present
value. Then the machine’s economic value to
the supply company is $9,000, but to the
radiologist it is $21,000.
Real estate workers often use an analogous
concept of “highest and best use” to describe
the particular use of a property in valuing
it. Note that these two values above do not violate
the economic “law of one price”, but rather
explain why the medical supply company is
happy to sell a machine, and the radiologist
is happy to buy it, for a $10,000 price. Some
firms can never use an advantage associated
with an asset, while others can. Such advantages
include economies of scale or scope,
marketing, technology edge, and regulatory or
tax advantages. Thus, the net value of an
asset and its associated tax credit differ across
firms, and this often explains why some
firms will sell it to others. In Section (6.) below,
changes to FASB 157 are suggested that will
more closely reflect economic reality and will
eliminate the accounting-driven part of the
financial crisis.
(2.1.3) Property–Right Complexity
Transaction Cost
There are a variety of state “anti
deficiency” laws regarding borrowers’ obligations when the
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loan balance of repossessed home exceeds the
home’s liquidation value. They were first introduced
during the Great Depression. For example, in
California [CCP 580(b)], New York
[RPAPL 1371], Arizona [ARS 33-729(A) and
33-814(G)], and North Dakota [32-19, 1-07],
borrowers are not liable for more than the
collateral of a principal residence. In California,
this applies even if the owner has converted
his or her home to a rental unit. Borrowers in
such states have an incentive to surrender
their (house) collateral in complete satisfaction
(“SCICS”)
of the loan, if they can buy an identical house across the
street for substantially
less than their home-loan balance, or rent
such a house at a rate that reflects this lower
value. But there was a strong tax impediment
to this incentive, and that impediment supported
the value of CMOs. SCICS implied immediate
(“forgiveness-of-debt”) ordinary income
equal to any loan balance in excess of the
home-collateral liquidation. A borrower who
chose SCICS incurred federal income tax on
such excess.
As stated in Section (2.), US housing prices
declined 23.41% from their peak in July 2006
to October 2008 (latest available).14
The
greatest declines were in the Phoenix, Las Vegas,
Miami, San Diego, San Francisco, Los
Angeles, Tampa, and Detroit areas, which had
40.55%, 39.15%, 37.69%, 36.11%, 35.93%,
34.34%, 30.51%, and 30.14% declines, respectively,
in that period. Thus many borrowers in some
states have had an incentive to SCICS,
which used to be retarded by the federal
taxes mentioned in the previous paragraph. However,
in December 2007 Congress passed the
Mortgage Forgiveness Debt Relief Act of 2007,
which waived such tax on principal
residences. This removed the impediment, thus increasing
SCICS and reducing the value of CMO cash
streams.
Investors must now construct more subtle
probability distributions over collateral surrender,
for that part of the (often thousands) of
home mortgages in a given MBS or CMO which
are in states allowing SCICS. Current home
owners who can use SCICS benefit. Bond
holders lose, including the average citizen
who has a pension or insurance policy that owns
such MBS or CMOs. Their retirement income
will be reduced. Anyone who will apply for a
home mortgage in the future will lose, in
the form of higher interest rates stemming from
the added risk of SCICS unbridled by taxes.
To the limited extent that this transaction cost
feeds the above-mentioned “market failure”,
it makes every citizen poorer and less secure.
One sign of this cost to home owners is the
refusal of some investors to buy MBS or CMOs
that include California home mortgages.
(2.2) IMPACT OF TRANSACTION COSTS ON CDO
MARKETS
The complexity, accounting, and
property-rights transaction costs above have had a
particularly
detrimental effect on the CDO market. Many
of these instruments are held by institutions
and investors who lack the mathematical
expertise to model their cash flows. In
particular, the original models used to
price new MBS and CMOs before June 2006
(whether those of the investor or the
investment banker selling them) had particular probability
distributions over home prices, and assumed
an economic environment with the tax
impediment described in Subsubsection
(1.1.3) above. First, the realization of those home
prices turned out to be in the lower few
percentiles of the probability distributions used,
and many CDOs, not associated with home
loans, suffered defaults in the top few percentile
of the probability distributions used to
model them. Second, the tax-impediment to SCICS
for loans associated with MBS and CMOs
vanished in 2007, which greatly increased SCICS
in those states that allow it.
Current and potential CDO investors lost
faith in the models, and have even less faith in
the more-complex models now required to
treat SCICS. They want out of their CDO positions.
The huge number of such CDO holders has
created an overhang of supply in the
market, which leads even
mathematically-sophisticated and well-capitalized investors
to
fear that whatever the current price is, it
will go lower.
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This fear is accentuated by the recent
experience of exactly such investors. Last year, many
of them correctly determined that some
high-quality CDOs were selling for less than the
present value of any realistic probability
distribution of their future cash flows. They purchased
such CDOs, often with leverage. As the
events described above unfolded, CDO
prices fell still further below any rational
valuation, even given those events. Most of these
sophisticated investors are hedge funds or
proprietary desks that must mark their CDOs to
market. Thus, they have been showing their
investors or parent organizations serious
losses, which together with the lack of
liquidity, have cut off their access to equity capital
and borrowing. This despite the fact that
the cash flow of these marked-down CDOs, from
purchase to maturity, is very profitable.
Hence the very market participants who might
bring price discovery and liquidity to the
market (and make a profit in the process), and
thus Pareto efficiency, are out of the game.
This explains the lack of a market in CDOs and
what passes for “market failure”.
The spread of the financial crisis from
markets for assets that were previous overvalued to
the markets for assets that have good cash
flows, is in large part a mark-to-market accounting
problem. Suggestion (E.) in Section (6.)
would attenuate this problem, by allowing
firms to value assets on a present value
basis. Note that insurance companies have a very
different regulatory regime, that does not
use FASB 157, and as a consequence, they have
been largely spared the financial panic of
many other finial institutions. The problems with
AIG stemmed from their London subsidiary,
which was not under US insurance regulation.
(2.3) LEVEL III ASSETS
The problems described above are
crystallized in the Level III assets held by major financial
institutions. CDOs are now Level III assets.
Level I assets are those assets for which there
is a liquid-market price available. Level II
assets are those assets that can be valued by a
close proxy asset and a no-arbitrage
argument. Level III assets are those assets for which
neither of these is available. The latter
require complex mathematical models and many assumptions.
At best, hedge-fund managers and the traders
on proprietary trading desks, that own these
assets, have good insight into their true
value. But internal and external auditors, risk
managers, rating agencies, and regulators
are far less knowledgeable about their worth.
Many Level III assets have been grossly
over-rated by rating agencies. As if that were not
bad enough, those same managers or traders,
that are responsible for marking their Level
III assets to market, are paid fees or
bonuses based on how much those marks rise each
year. Thus, many Level III assets have been
marked far above any reasonable measure of
their worth. The CDO market failure
immediately focused investors on these problems,
making them undesirable, and thus virtually
stopped trading in Level III assets.
Many of the major investment banks and other
financial institutions, with substantial Level
III assets and high leverage, have
overvalued Level III assets. This has occurred to such an
extent that they were bankrupt, or could
have quickly become so. They may own CDOs directly
and/or have exposure to them via
credit-default swaps. Note that mathematical
complexity masks reality enough so that many
of these obligations were grossly overvalued
by such proprietary desks, while other firms
have recently marked the same assets at values
far below a rational present value of their
cash flows. Sheer uncertainty is added to the
already-scary credit markets by firms
unpredictable adjustments to Level III values.
Examples of the July 2008 ratios of Level
III assets to equity are reported by The Financial
Times website FT.com ($s in billions):
Citigroup ratio 1.05 = $135/$128; Goldman Sachs
ratio 1.85 = $72/$39; Morgan Stanley ratio
2.51 = $88/$35; Bear Stearns ratio 1.54 =
$20/$13 billion; and Merrill Lynch ratio
0.38 = $16/$42. Even if the illiquidity and overvaluation
of these assets has not made them bankrupt,
they are in danger of spiraling to
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such a state in a few days if suspicions
develop that their Level III are substantially overvalued,
because they will not be able to trade.
Counterparty will not trade with them if: (i.) it
is widely feared their assets may be marked
down far further, or (ii.) if it is widely believed
that any of several credit-worthiness
measures drop below contractually-specified levels (a
“credit event”) in any of their hundreds of
bilateral ISDA (International Swap Dealers Association)
agreements. These measures involve
mark-to-market values and various financial
ratios. Worse yet, failing firms may default
or delay payment on some obligations to otherwise
solvent firms, leading to a cascade of
insolvencies.
(3.) SPILLOVER TO ALL FINANCIAL MARKETS
(3.1) SPILLOVER TO FINANCIAL INSTITUTION’S
BALANCE SHEETS
There is an enormous quantity of Level III
assets (including CDOs backed by US home
mortgages) widely held by the major
participants in the US credit markets. These participants
include the commercial and investment banks,
hedge funds, insurance companies,
and other financial institutions around the
world. Hence, the fall in Level III-asset prices
(where these prices can be found), the lack
of liquidity and price discovery, and the consequent
uncertainty have combined to impair the
balance sheets of these participants. This
has recently reduced the ability (at least
temporarily) of many prominent firms to act as
counterparties to trades in the general
credit markets.
Some of this risk of CDOs and other Level
III assets has been passed from one financial institution
to another via credit-default swaps (“CDS”).
The writers (issuers) of those CDSs
did not fully factor the transaction costs
described above into their valuations, and in general
grossly under-estimated the risks. This had
two pernicious effects. The first effect is
that it gave comfort to many investors
supplying capital to firms that purchased CDOs, because
much of the ultimate risk was insured, via
these CDSs, by firms with high credit ratings.
The most prolific issuer was London-based
AIG Financial Products, which is a subsidiary
of previously-AAA-rated AIG, that guaranteed
its obligations. The second effect is
that it spread potential insolvency to firms
that were not otherwise heavily involved in
CDOs, such as AIG and many of its
counterparties.
(3.2) BALANCE SHEET EFFECTS ON FALLING &
IRRATIONAL RELATIVE PRICES
The shock of such firms (like Bear Stearns,
Merrill Lynch, Lehman Brothers, Morgan Stanley,
AIG, and Goldman Sachs) suddenly being
unworthy to trade with in September 2008,
has contributed to a loss of investor faith
in many of the institutions and mechanisms of
the general credit markets. These investors
wonder who they can trade with safely and just
what they can count on after such a fall
from grace of the financial titans. They have been
fooled and disappointed by: investment banks
who sold CDOs, mathematical models that
valued such obligations, internal and
external accountants and rating agencies that determined
or opined on their valuations, as well as,
firms and funds that invested in such obligations.
This has stifled many normal commercial
activities of the credit markets, and
brought on the specter of bankruptcy or
Government bailout to many prominent firms.
A frightening consequence of this loss of
faith is its contagion from CDOs to almost all nongovernment
financial instruments: debt, equity, and
commodity. That has led to a write
down of the value of privately-issued
financial assets across the board, which has weakened
corporate and hedge-fund balance sheets, and
thus greatly impaired commerce. This will
be an economic disaster if it persists. The
switch of TARP policy in October 2008, from buying
illiquid fixed-income assets of financial
institutions to injecting capital into those institutions
via preferred stock purchases, recognized
this phenomena and its gravity.
US Treasury bonds are in great demand as the
other markets are becoming far less liquid
and investors are panicking. But even that
market is adversely affected by the panic, in
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that Treasury debt exhibited persistent
relative mispricing, and have Treasury prices have
risen irrationally. Hedge funds and
proprietary traders do not have sufficient capital and
borrowing capacity to arbitrage away such
mispricing. For example, on 30 October 2008,
nearly identical Treasury bond traded at
very different prices. In particular, on-the-run
(i.e., the newest) 10-Year Treasury bonds
yields were 40 basis points lower than yields of
such off-the-run (i.e., older than on the
run) bonds. At the same time, the 30-year Treasury
bond yield was 50 basis points higher than
the 30-year swap rate for 3-month Libor. This
suggests that Libor is expected to be safer
than Treasury debt. On 18 December 2008, the
Treasury reported that the average market
yield for 30-year Treasury bonds was 2.53%.
That yield is absurd in the face of the
likely inflation and higher interest rates in the next
decade, as its future cash stream will then
be discounted at a much high rate.
Such crazy relative pricing and absurdly low
yield are explained in part by traders being
forced out of positions for margin calls,
redemption, and/or reduction of credit lines, all
stemming in part from the distortions of
mark-to-market accounting. They held positions
that were very profitable arbitrages, if
they could have stay in them to benefit from the cash
flow. Unwinding those trades pushed prices
further out of line, making the arbitrage even
larger for anyone with the capital to hold
the positions. This is the key to spiraling down
and irrational relative-price levels, which
is hobbling the financial markets.
Many investors are not valuing assets
through the normal assessment of their probability
distribution of future cash flows, but
rather on how they think other investors will value assets.
It is as if each investor believes: “I am
rational, but I am choosing a strategy that is
optimal, given that the other investors are
panicked into irrational behavior”. This perceived
irrationality leads investors to shun assets
that are offered far under any rational
value on a discounted-cash-flow basis. Such
psychology is the heart of the financial crisis.
While the specific steps enumerated in this
paper to improve the credit markets are important,
none of them will help if this market
psychology persists. That suggests the announcement
and implementation of those steps, and/or
other such steps, is as important
as the steps themselves. The Government must
carefully craft and stage manage the presentation
of all its steps at one time, to impress and
dazzle the financial press and the markets
with the Government’s understanding of and
solution to the crisis. If the markets have
faith in the Government’s solution, then its
success will be a self-fulfilling prophecy.
The price drops across all classes of
assets, not guaranteed by the Government, have
greatly reduced the wealth of US consumers.
The famous “Pigou Effect” is the reduction in
consumption when people become less wealthy.
This reinforces such fall in asset prices as
private companies have less sales and
profits. As real output drops, in the face of the
commercial-credit shortage (reducing output)
and the Pigou Effect (reducing demand), there
are fewer good and services being chased by
the money supply. This will exacerbate the
high inflation that the bail out of the
financial crisis will eventually bring, as explained in
Subsection (6.3) below. If unchecked by
Government action, this mutually-reinforcing
combination, of businesses not being able to
finance output, consumers not buying output,
and asset prices falling, will culminate in
widespread retail-store closings, which will herald
a depression.
(4.) SIDE EFFECTS OF THE FINANCIAL CRISIS
There are several negative side effects of
the financial crisis and each in turn exacerbates
the crisis. One of the most important of
these is the destruction of home-mortgage collateral,
that supports the enormous volume of MBSs
and CMOs outstanding in the US. Another
is management of firms taking much greater
risks, because the Government took a
(just under 80%) equity stake in some in
some firms that they bailed out, like AIG. The
other side effects are less immediate. They
include massive commercial real-estate defaults,
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higher crime and drug-abuse rates, less
state and local spending on infrastructure, less
state and local, as well as, individual
spending on education. Each of these will retard economic
growth.
(4.1) HOME-COLLATERAL DESTRUCTION
A little-thought-about, but now-crucial,
consideration in the value of extant CDOs, backed
by home MBS, is the shortage of competent
personnel to assess and negotiate “work outs”
or to foreclose and resell collateral. In
the best case a delinquent home mortgage is:
(i.) modified so the borrower remains in and
maintains their home via mortgage modification
or exchanged for a rental agreement (in a
way that benefits both the homeowner
and CMO holder), or
(ii.) foreclosed and the home maintained and
resold for its market value in an orderly
manner, without damage, disrepair,
unnecessary ill effects on neighboring homes, or
interruption of insurance and property-tax
payments.
In the worst case, the absence of such
personnel has resulted in needless home abandonment,
which in turn has led to lower property
values and contagious abandonment of
neighboring homes. This has caused social
trauma for the home-owning families involved,
as well as, reduced the mortgage-collateral
value as homes fell into disrepair, were vandalized,
insurance and property taxes were unpaid,
and municipalities seized homes.
Most home-mortgage companies and servicers
appeared competent at originating, processing,
and servicing home loans when sales were
booming. However, they do not have the expertise,
staff, or organization to deal with workouts
and foreclosures at the current scale of
delinquencies. In general, such
organizations lack even the ability and inclination to
retain
and manage well-qualified contractors to
perform these services.
One frightening possibility in the next
three years is that part of the savings & loan crisis
will repeat. In particular, that there might
be massive: (a.) home-mortgage delinquency,
(b.) mortgage-originator failures, and (c.)
numbers of unemployed mortgage salespeople becoming
mortgage-delinquency managers attempting the
tasks in (i.) and (ii.) above. On average,
they would likely mirror the horrendous
performance of unemployed savings and
loan officers who became Resolution Trust
Corporation (RTC) officers.
From the 1989 establishment of the RTC until
all its assets were sold in 1995, 29.4%
($152.9 billion) of the $519.0 billion
value, in thrift assets acquired by the RTC, were lost.
This cost the Government $123.8 billion, and
cost the owners and creditors of 1,043 failed
thrift institutions $29.1 billion.19
That totals
$191.4 billion in July 2008 dollars. This loss
transpired in the very favorable housing and
business environment during which the RTS
operated (August 1989 to December 1995
inclusive). In that period the OFHE0’s repeatpurchase
House Price Index rose every quarter,
growing 27.04% in total and 3.90%/year on
average, while real output (adjusted for
inflation) grew 15.97%.20
This
contrasts with
much-less-favorable circumstance of the
current crisis, in which house prices fell 21.77%
since June 2006,21
and real
GDP fell at a rate of 0.5%/year in the third quarter of
2008.
Assume that only subprime, Alt-A, and
home-equity home mortgages currently outstanding
19
Weiss, N. Eric,
“Government Interventions in Financial Markets: ...”,
Congressional Research Service, 25 March 2008.
20
This is the Office
of Federal Housing Enterprise Oversight’s Repeat-Purchase
House Price Index. GDP rose every
quarter but one for a total 35.99% growth,
which is an compounded average of 5.04%/year. Real GDP
(i.e., GDP adjusted
for inflation) in that period rose every
quarter but two for a total 15.97% growth, which is a
compounded average of
2.36%/year.
21
We used the
S&P/Case-Shiller Home Price Index for this recent period
because it is widely regarded as a better measure
than the OFHEO Index, but could not use it
for the 1989 to 1995 because it did not exist then.
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default ever have any default. There are
about $6.5 trillion of such loans, compared to the
$0.649 trillion in assets acquired by the
RTC in 1989 in July 2008 dollars. That is 10
times as much assets and those assets have a
much higher delinquencies. The same proportion
of losses as the RTC suffered, with better
assets in a much better economic climate,
will leave us with $2.941 trillion in lost
collateral. That is more than 1/5 of the $14.5 trillion
of US GDP (20.3% of all the US goods and
services produced in 2008).
(4.2) RISK TAKING BY RESUCED FIRMS
The US Government now owns almost 80% of the
equity in some rescued firms, like AIG.
This has created a severe
incentive-compatibility problems between the management of
those firms and the Government as owner and
as watch dog of the country’s economic
health. The managers have little to loose
and much to gain by taking big risks, as their
share part of the profits but almost none of
the losses. Private stockholders, who would
otherwise police this behavior, are now
largely replaced by Government owners, who have
not the inclination, skills or incentive to
do such policing.
AIG in particular, has received a $150
billion Government bailout.22
Naturally, the
managers
of AIG are putting that to use to make as
much bonus and stock-option profit as possible,
without the usual oversight of private
stockholders. These managers do not share
much in the downside, and thus have a
powerful incentive to take big risks with that
money. After November 2008, AIG has been
booking a surge of commercial-insurance premium
by quoting much lower prices than their
competitors. Much of this business has
been at half the rate of competitors.23
The competition
has responded by lowering their
prices, so we getting systematically the
wrong incentives for risk taking by insurance buyers.
Sadly, many businesses are buying AIG
commercial insurance because the Government
now stands behind them, instead of shying
away from too-good-to-be-true prices that
would ordinarily make them wary of the
insurer’s ability to payout claims. It seems the
Government has leaned nothing from the
lessons of the bad policy milestones and developments
[enumerated (i.) thru (vii.) and (a.) thru
(f.) in Section (1.)], the perverse incentives
they created, and bad economic outcomes that
eventually resulted.
(5.) DELEVERAGING, WRITE−DOWNS,
AND DEFLATION
We have not addressed two recent effects on
the money supply:
(i.)
deleveraging of
US dollar
debt, i.e., reduction in US-dollar loans
outstanding, and
(ii.)
writing-down of
US bank
assets. Both phenomena are reported
worldwide, and if true, represent dangers to the US
economy, which offset temporarily the
inflation dangers of the bailout described in Subsection
(7. 3) below. Existing US-dollar loan
balances are reportedly being repaid faster than
the sum of: creation of new loans and the
net increase in existing loan principal. As mentioned
in Subsections (2.2) above, many financial
assets are being written down as their
market or perceived market value falls. In
this analysis, we will divide US dollar loans to
nonbanks into two classes: lending by
nonbanks and lending by banks.
Changes in balances lent by nonbanks do not
affect the US money supply as their issue
and repayment occurs by movement of money
between the demand deposits of lenders and
borrowers, thus not changing the total
demand deposits outstanding. However, changes in
bank lending does, according to classic
economic theory, effect the money supply, as borrowers
reduce their demand deposits to pay off
loans. A $1 reduction does not increase assets
of the bank, but rather frees up $0.10 of
their reserves, so that the bank can lend that
22
“AIG gets $150
billion government out; posts huge loss”. Reuters Business &
Finance Section 10 November 2008.
23
I obtained this data
from a few of the largest US commercial insurance brokers.
It can only be verified by comparing the
relative prices quoted of different
insurance carriers like AIG, and by comparing current quotes
with those made before
August 2008.
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$1 again. If the bank does not lend that
dollar, then the money supply is decreased (deflated)
by $1. That reduction is not increased by
the money multiplier.
As US banks write down the value of their
financial assets, their bank capital falls. However,
US banks must maintain 8% of assets in bank
capital, and these assets (in the language
of bank regulation) include demand deposits.
Bank capital is bank assets minus
bank liabilities. Thus, writing down an
asset in a bank’s capital by $1 theoretically reduces
the money supply by whatever reduction in
lending occurs, up to a maximum possible reduction
(for banks fully lent out with respect to
bank capital) of $1/0.08 = $12.50.
The factors in (i.) and (ii.) decrease the
maximum possible money supply, and thus in the
long run might offset money created for the
bailout. But, US banks are not fully lend out,
so the multiplier does not immediately come
to bear. Thus loans create money more than
vise versa.24
In any
case, the Fed Statistical Release H.3, H.6, and H.8 on 19
December
2008 shows each of measure of bank reserves
and money supply (net assets of commercial
banks, M1 and M2 money supply) rising over
the last three months and in comparison to
last year. Any deflation that might occur
from reduced bank lending will soon be swamped
by the inflation coming from the bailout as
explained at the end of Subsection (6.3) below.
(6.) RECCOMMENDED GOVERNMENT ACTION
Government action should accomplish two
tasks. First, it should immediately stop the general
market panic, and bring rationality and
price discovery to the financial markets. Second,
it should do so in a way that minimizes the
rise of inflation. However, the least possible
inflation in this situation will be high.
(6.1) Recommended Treasury Actions:
(A.) Purchase of preferred stock in US
money-center banks and the principal Treasury
dealers to bolster their balance sheets.
This will help restore counter-party
worthiness of major financial institutions, which is
a necessary, but not sufficient, condition
for the financial markets to function. The
Treasury has already done much of this.
(B.) Exchange certain existing MBS and CDOs
(say “Treasury Blessed “Obligations” or
“TBOs”), that are backed by at least 80% US
collateral, from any holder for Treasury
“warehouse receipts”. Make them more
attractive and less mysterious to investors,
auction them, and turn over the auction
proceeds to the receipt holders.
(B.1) This is subject to a minimum size of
the TBOs exchanged and of the issue involved.
Require, by law, issuers and servicers of
any TBOs acquired to submit a
report on the title and liens status of
TBOs.
(B.2) Where feasible, combine the slices of
common TBOs to reduce complexity.
(B.3) Assign collection of TBO’s underlying
debt over 180 days delinquent to the IRS.
The IRS should be funded for this service.
(B.4) Waive all Federal tax (inheritance tax
too) on income from any instrument eligible
to be a TBO. Encourage the state and local
governments to so the same.
(B.5) Indemnify any holder of TBO from loss
because of title or lien, with specified in-
24
This point is part
of a enlighting description of relationship of money supply,
real output, and national debt.
“In
the real
world banks make loans independent of
reserve positions, then during the next accounting period
borrow any needed reserves.
The imperatives of the accounting system, as
previously discussed, require the Fed to lend the banks
whatever they
need.”
Mosler, Warren B. Soft Currency Economics, 1994. Available
at www.gate.net/~mosler/ frame001.htm. In this
case, reality follows Mosler’s theory, as
widespread bank deleveraging did not reduce the money
supply.
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demnity-payment timing. Treasury should
contract out title and lien checks before
auctioning the TBOs. The Treasury should be
funded for this cost.
(B.6) Contract out TBO analysis, valuation,
history, and public (internet) access to related
proprietary databases (e.g., those of Bear
Stearns and USATitle). Contract
the workout and collateral-management
services for TBOs under a unified and
consistent system. The Treasury should be
funded for this cost.
(B.7) Immediately payout the cash stream as
received from the TBOs to the receipt
holders. After acquiring a substantial part
of all US CDOs, an auctioning decision
should be made: will the TBOs fetch more as
individual bonds or as part of
a single homogenous issue. A holder of any
such single issue would receive a
share of all TB0’s cash stream. It is a
question of whether complexity trumps
homogeneity in the market. Auction off the
TBOs accordingly.
This is aimed at avoiding the collateral
losses discsses in section (4.) above.
(C.) Guarantee timely repayment of 80% of
certain classes of new private loans to US borrowers,
that meet certain minimum standards. These
classes are those supporting
key areas of the economy, like student,
home, and auto loans. Apply (B.1) through
(B.4) to the loans involved as if they were
TBOs.
(D.) Encourage the Financial Accounting
Standards Board to change SFAS 157. For each
fixed-income asset independently, the holder
should be able to book its value as the:
(D.1) current actual or inferred market
price (via the market price of a close asset and
a no-arbitrage argument), or
(D.2) present value of the holder’s intended
expected-marginal cash flow attributable
to that asset, using appropriate discount
rates and risk adjustments.
(6.2) Recommended Congressional Actions:
(E.) Congress accommodates (B.) above by
amending the Mortgage Forgiveness Debt Relief
Act of 2007 to waive recognition of ordinary
income for debt forgiveness on primary
residences only if:
(E.1) borrower obtains consent of a servicer
or substantial holder of the mortgage, or a
bankruptcy court, associated with the debt
in question; or
(E.2) demonstrates to the IRS that he or she
was the victim of any predatory lending.
This will remove the incentive to misuse
SCICS described in Subsubsection (2.1.3)
above, except where it is part of a
resolution or untoward lending.
(F.) Legislate liability for valuations in
major financial markets, including the major overthe-
counter markets and hedge funds. Hold anyone
who is responsible for valuing an
asset or liability in such markets
personally liable civilly and criminally for any substantial
valuation errors attributable to substantial
instances of: negligence, conflict
of interest, or fraud. This liability is to
anyone or entity who suffers from such valuation,
or who regulates the person or entity
responsible. A valuation that meets the IRS
“substantial authority” or the general
“reasonable man” tests will exempt the valuer.
But he or she will be responsible for being
aware of the general complexity of the valuation
involved to the extend of standard industry
practice.
(6.3) Recommended Federal Reserve Actions:
(G.) Allow banks to post TBOs as reserves,
up to some prudent limit.
(H.) In conjunction with the FDIC, require
all US banks to lend 80% of their previous 5-
year average in each major category of
lending, as a condition of maintaining their
FDIC insurance (with an exception process
for banks in special circumstances).
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(I.) For whatever period the Fed plans, pay
interest on member bank reserves only up to
the minimum reserve requirement for the
volume of demand deposits the bank has.
This will avoid an additional disincentive
to lend.
(6.4) Recommended Actions for all the
Entities Above
(J.) Hold a carefully-staged announcement by
the President, Treasury Secretary, Fed
Chairman, and Congressional Leaders. It
should be thoroughly researched and planned
for maximum psychological impact on the
financial markets before consumer and
investor psychological is further shaken by
widespread retail-store closings.
In implementing borrowing and guaranting of
borrowing, there is an important tradeoff for
the Government to ponder. The Treasury
reduces the money supply when it borrows and
Government agencies and private companies do
not. But the former borrows at a lower cost
than the latter.25
As
explained in Section (7.3) below, high inflation is a real
danger of the
bailout. Thus, Treasury borrowing
temporarily reduces this danger. However, guaranteeing
agency and private debt, instead of the
Treasury borrowing directly, may be justified because
it improves the liquidity of such debt and
it is the lack of such liquidity that is at the
heart of the financial crisis.
(7.) SHORT-TERM EFFECTS OF GOVERNMENT ACTION
(7.1) Relation of Money Supply to Fed and
Treasury Actions
In this analysis we will use the M1
definitions of the money supply. M1 is all the US-issued
cash and coins in circulation and all the
US-dollar demand deposits (checking accounts) in
US banks. M2 is M1 plus US dollar: (a.) time
deposits, money market mutual-fund shares,
money market deposit accounts, and overnight
repurchase agreements, all in the US, and
(b.) overnight Eurodollar deposits
(US-dollar demand deposits in foreign banks). If a bailout
delivers an amount of money to bond or
equity holders (other than US Government), then,
through the money-multiplier effect, that
amount is theoretically expanded.26
We also
calculated
the bailout effects on the M2 and MZM money
supplies and found that they were
proportional to the effects on M1, so we
have omitted them here.
But, the emergence of sweep time-deposit
accounts and other developments has made reserve
requirements less of a constraint and less
important, and thus banks are not lending
to their limit.11
The M1
money multiplier is the ratio of M1 to currency and bank
reserves,
and it has fallen from about 3.1 in 1987 to
about 1.2 now. The M2 money multiplier is the
ratio of M2 to currency and bank reserves.
It rose from 5.3 in 1987 to 8.6 in January 2007,
and then gradually fell to 6.9 in October
2008. These multipliers has little effect in the
short run, but might in the long run,
similar to speed limits for very unhurried save drivers.
Classical economic theory teaches: when a
borrower pays money back to a (nonbank)
lender, it: (a.) decreases the money supply
by reducing the borrower’s checking account,
and (b.) increases the money supply an equal
amount by increasing the lender’s checking
25
This is demonstrated
by 30-year Ginnie Mae bonds (with full-faith-and-credit
Government guarantee) trading with 2.6%
higher yield than Treasury bonds in November
2008. Similarly, Crown corporations have illustrated this
point by
borrowing at higher rates than the Crown,
e.g., the full-faith and credit bonds of the Canadian
Mortgage and Housing
Corporation (founded in 1944) has always
paid higher interest rates than The Bank of Canada.
26
The Fed’s reserve
requirements for demand deposits since 20 December 2007 have
been 0%, 3%, and 10% for deposits
under $9.3 million, between $9.3 and $43.9
million, and over $43.9 million, respectively.26
For time
deposits it is 0%.
Thus each bail-out dollar disbursed could
theoretically produce up to $10 of new demand deposits (and
infinite dollars of
time deposits), since that dollar becomes an
extra dollar of reserves when it is deposited, that will
support up to $10 of new
loans. These loans become new demand
deposits and currency. See footnote 15.
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account. If the lender is a bank, then the
money supply decrease does not reverse until it is
lent out again. In a cash rescue, the
borrowers do not repay and thus do not reduce their
checking accounts, but a nonbank bond holder
adds the government’s rescue payment
(money created out of thin air) to their
checking account. The money multiplier compounds
that increase in the money supply.
By law, the TARP must be funded by the
Treasury issuing additional debt. As the Treasury
buys assets from, or invests in (i.e., buys
preferred stock of), financial institutions, there
will be a rise in the demand deposits of
those institutions. This rise will equal the fall in the
demand deposits owned by the purchaser’s of
that additional Treasury debt. Hence, there
will be no immediate rise in the money
supply. But the money supply will rise as that new
debt delivers coupon and principal payments
in the future. More importantly, the additional
Treasury debt issues will increase the total
supply, and thus lower the value of such
debt, i.e., raise Treasury interest rates.
This in turn will raise all other US-dollar interest
rates and crowd out some private borrowing.
The Fed and the FDIC are also major players
in the bail out, and their rescue payments
will be pure increases in the money supply.
How much rates rise depends on many factors
that determine the elasticity of interest rates
with respect to the supply of Treasury debt.
A key factor is the amount of money created by
the Fed to accommodate the purchases of
Treasury bonds. But, increasing the money supply
creates inflation, which raises interest
rates. The Federal Home Loan Bank Board
(“FHLBB”) also borrows but that does not
count in the National debt.
(7.2) Bail Out’s Effect On The Money Supply
and National Debt
The New York Times Business Section featured
“Tracking the Bailout: The Government’s
Commitments” on 25 November 2008. It
reported in trillions:
(i.)
$1.7 Fed loans;
(ii.)
$3.0
preferred stock and mortgage purchases by
FDIC, Treasury, and FHBB ($0.60); and
(iii.)
$3.1 debt guarantees
by Fed, Treasury, and FDIC. This is consistent with
Government
pronouncements before and since, and it
totals $7.8 trillion. On 6 January 2008, the Congressional
Budget Office (“CBO”) estimated27
a $1.2
trillion 2009 budget deficit, excluding
the President-elect’s Stimulus Package; and
the New York Times reported: (a.) “Presidentelect
Barack Obama on Tuesday braced Americans for
the unparalleled prospect of “trilliondollar
deficits for years to come”;
and (b.) “Even
as he prepares a stimulus plan that is expected
to total nearly $800 billion in new spending
and tax cuts over the next two years”.
To calculate the impact of these Government
policies on the money supply and the National
Debt by 30 September 2011, we assume:
(Ι.)
no guarantees in
(iii.) are ever paid except the initial $100 billion
Treasury guarantee
on each of Freddie Mac’s and Fannie Mae’s
losses, which have already occurred;
(II.) loans in (i.) and purchases in (ii.)
do not ever increase from these levels;
(III.) financial bailout and stimulus
package are implemented in 3 years;
(IV.) CBO’s projection of $1.2 trillion/year
Government deficit continues for 3 years and is
financed by new debt;
(V.) debt service payments28
on the
Treasury new and previous National Debt for the next
three fiscal years totals 6% and 8%,
respectively, of such debt; and
(VI.) Fed’s announced $620 billion temporary
reciprocal-currency arrangements (swap
lines) with foreign central banks is
unchanged and fully used for 3 years.
Under these optimistic assumptions we
compute the classical-economic effects of the bailout
on the money supply and the National Debt in
three years. We do this for two polar
cases of Treasury borrowing. Congress can
choose Case 1: minimum increase in borrowing
27
Congressional Budget
Office. “The Budget and Economic Outlook: Fiscal Years 2009
to 2019”. January 2009.
28
All principal
repayments and interest payments due on debt during the
period in question.
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(in the National Debt) and maximum increase
in money supply (in M1). This is accomplished
by the Fed accommodating the Treasury in not
borrowing beyond funding the previous
National Debt and new deficits. Congress can
instead choose Case 2: minimum increase
in money supply and maximum increase in
borrowing. This is accomplished by
Congress authorizing a large-enough increase
in the National Debt (beyond the deficit and
the bailout debt already authorized) in
order to “soak up” both: the new money directly created
by the bail out, and the debt service on
that new debt.
CASE 1 CASE 2
(All $ amounts in trillions) no additional
borrowing borrow enough to
to soak up money soak up new money
created by bailout created by bailout
M1 Money Supply in 3 Years
Fed disbursing (creating) money for:
loans & credit lines $ 1.710 $ 0.000
commercial paper 1.600 0.000
US-dollar swap lines 0.620 0.000
buy AIG assets 0.053 0.000
Subtotal money created directly by Fed
bailout 3.983 0.000
Treasury debt service (pay out) on debt
funding
previous National Debt 0.064 0.064
CBO projected current deficit for 3 years
0.216 0.216
President-elect’s proposed Stimulus Package
0.048 0.048
direct Treasury-bailout debt 0.054 0.054
soak up direct Fed-bailout rise in M1 money
0.000 0.366
Subtotal money created by debt service 0.382
0.748
Subtotal new money before money multiplier
4.365 0.748
Additional M1 money from M1 multiplier 0.873
0.150
Total increase in M1 money supply 5.238 =
364.8% rise 0.898 = 62.5% rise
Existing M1 money supply on 30 Sep 2008
1.436 1.436
Total M1 money supply after bailout 6.674
2.334
National Debt in 3 Years
Treasury borrowing for:
TARP $ 0.700 $ 0.700
guarantee of Freddie Mac 0.100 0.100
guarantee of Fannie Mae 0.100 0.100
debt issued to soak up rise in M1 money
0.000 4.365
Subtotal new bailout-direct & soak-up debt
0.900 5.265
Treasury debt to fund
previous National Debt 0.802 0.802
CBO projected current deficit for 3 years
3.600 3.600
President-elect’s proposed Stimulus Package
0.800 0.800
Subtotal new debt to cover debt service
5.202 5.202
Total new debt in 3 years 6.102 = 60.9% rise
10.467 = 104.4% rise
Existing National Debt 10.650 10.025
Total National Debt after bailout 16.127
20.492
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$10.03
old
debt
$3.60 deficit at
current pace
$0.90 bailout debt
$0.87 M1 multiplier
$3.98
Fed direct bailout
spending
$1.44 old M1
money supply
364.8%
rise to $6.67
M1 Money Supply
CASE 1: SMALLER DEBT & LARGER MONEY
SUPPLY IN 3 YEARS
(all $ amounts in Trillions)
National Debt
debt service on: old debt
service $0.06, deficit for
= 3-years $0.216, Treasury
direct bailout debt $0.05,
Stimulus Package $0.48
60.9.3%
rise to $16.13
$0.80 serve old debt
$0.80 Stimulus
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(7.3) Likely Effect of Bailout Funding and
Limitations of Treasury Borrowing
To put these Cases 1 and 2 in perspective,
US Gross Domestic Product (“GDP”) is $14.5 trillion
per year. If the real output of goods and
services (i.e., output adjusted for inflation)
does not rise in the next three year, a
larger money supply will be chasing the same or less
goods and services. We have to add to this
whatever increase in money supply that the Fed
$10.03
old
debt
$3.60 deficit at
current pace forecast
by CBO
$1.52 old M1
money supply
104.4%
rise to $20.49
62.53%
rise to $2.33
National Debt M1 Money Supply
CASE 2: LARGER DEBT &
SMALLER MONEY SUPPLY
IN 3 YEARS
(all $ amounts in Trillions)
$3.98 Fed direct
bailout
spending
$4.37 debt “soaks up”
new money from
Fed bailout & debt
service on it
$0.90 bailout debt
$0.80 Stimulus
debt service on the = $0.80
debt service that funds
previous National Debt
$0.75
= debt service on:
previous National
Debt $0.6, 3-year
deficit $0.22,
Stimulus $0.05,
soak-up debt
$0.37
$0.15 M1 money
= multiplier
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creates to accommodate the bond issues that
the Treasury uses to help fund the bail out.
This is the demand-pull that spells
continued inflation, and thus the expectation of inflation,
both of which raise interest rates. If
things turnout worse than we assume in the second
paragraph of Subsection (7.2) for the next
three years, the money supply and Treasury
debt will grow even larger. Important worse
outcomes in (6.2) include: more of the myriad
Government guarantees in (iii.) above come
due, more firms are bailed out, the annual deficit
grows, and interest rates rise.
It is the prospect of these changes that
lead to the suggestion in Section (6.) (B.) above: any
large-scale CMO and CDO purchases that maybe
contemplated should be paid for with
warehouse receipts
instead of money.
Note, such comprehensive purchases are not part of
the current bail out enumerated in (i.),
(ii.), and (iii.) of Subsection (7.2) above from Treasury,
Fed, or FDIC. The receipts approach will
avoid raising the money supply even more
than calculations in (7.2).
Congress has a choice between: Case 1
(364.8% higher M1 money supply and 60.9%
higher National Debt), Case 2 (62.5% higher
M1 money supply and 104.4% higher National
Debt), or of something in between those two
polar cases. But there are limits to the market’s
appetite for Treasury debt and thus the
feasibility of Case 2. A larger supply of Treasury
bonds will lower the market price of those
bonds, and thus by definition raise interest
rates, distinct from the rise in interest
rates caused by inflation. Furthermore, massive new
Treasury debt will crowd out private
borrowing that supports production and consumption.
Thus, Treasury borrowing, to reduce the
money supply, will reduce the goods and services
being chased by the money supply, and thus
raise inflation still further. The larger Case 2
debt minimizes M1 money supply growth at an
average of 17.6%/year compounded for
three years, but simply postpones creating
more money.
If the GDP does not grow over the next three
years, then there will be at least 17.6% inflation/
year. Since interests rates are usually
greater than inflation, his suggests that much
inflation in the period. The Case 2 National
Debt soaring 104.4% in three years will flood
the market and lower the price of Treasury
debt, i.e., raise interest rates. These two effect
point to between 10% and 20% short-term
interest rates (e.g., 3-month Libor) sometime in
the next one to three years. That in turn,
will raise the interest cost of financing the
$20.492 trillion (extant in 3 years under
Case 2) National Debt to between $2.049 and
$4.098 trillion/year, which is 13.1% and
26.2%, respectively, of 2008 GDP. That compares
with about $412 billion of interest expense
in 2008.
I was asked to predict GDP, employment, and
other economic statistics. They are not as
easy or direct to compute as money supply
and National Debt from the Government’s current
bailout commitments. However, my best
estimate (assuming the Government does not
restore consumer and investor confidence
soon), is as following. First, deficits as a proportion
of tax revenue unseen since WWII. Second, 10
to 20 for almost everything in one to
three years: 20% of retail-store units
close; 10% to 20% unemployment, inflation, and 3-
month Libor; 10% to 20% more poverty and
crime; $20 per barrel oil; and 10% less GDP
per capita. The latter two estimates are
adjusted for inflation from 1 October 2008 prices.
(8.) LONG-TERM EFFECTS OF GOVERNMENT ACTION:
TIPPING POINTS
If any of the scenarios described in
Subsection (6.) above materializes, then the credit markets
and world opinion will expect prolonged
inflation in the US. This will likely provoke
two successive psychological-tipping points.
These tipping points are similar in some ways
to the fear of a bank failure that becomes a
self-fulfilling prophecy, but are likely to be
based on more-realistic fears. The mere
prospect of these tipping points can cause investors
to act before it is justified by economic
circumstances. This would cause foreign investors
to dump US debt or dollars before others do,
accelerating the run into such a selfFinancial
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fulfilling prophecy.
(8.1) Foreigners Dump US-Dollar-Denominated
Debt
Foreigners will stop wanting to hold US
dollar-denominated debt because its value will be
expected to dissolve with high inflation. To
not hold such debt, they must sell it, i.e., exchange
it for US bank demand deposits. This implies
US Government debt prices will fall,
which raises US interest rates by
definition. It also leaves foreigners with far more US
dollars
than they hold in equilibrium, which implies
that they will sell the dollars for foreign
currency. Thus, the dollar will fall sharply
against foreign currencies and that raises the
cost of imports and thus raise inflation
still further. New reports are starting to report the
first tendencies in this direction. On 8
January 2008, the International Herald Tribune
Business with Reuters section had an article
entitled “US debt is losing its appeal in China”.
It included:
"All the key drivers of China's Treasury
purchases are disappearing," said Ben Simpfendorfer, an
economist
in the Hong Kong office of the Royal Bank of
Scotland. "There's a waning appetite for dollars and a
waning
appetite for Treasuries. And that
complicates the outlook for interest rates." It reported
that about 70% of
China’s public holding of foreign debt is US
dollar debt, i.e., about $1.43 trillion, and that China is
expected
to decrease it foreign debt holdings.”
(8.2) Foreigners Dump US Dollars
If the bailout leads to fear of high
inflation, as suggested in Subsection (2.2) above, and US
dollars are perceived by foreigners as
falling against other currencies long term, then they
will not want to hold US dollars. To stop
holding dollars, foreigners will buy US goods and
services with those dollars. That might seem
fine for US producers, but the US economy
will suffer “Seigniorage Shrinkage".
Seigniorage is the profit a government makes on the
money it creates, i.e., the value of the
things it buys with the money it circulates (by buying
goods and services) minus the cost of
creating the money.
Seigniorage Shrinkage works as follows.
Until now, foreigners have produced goods and
services, which were consumed in the US and
paid for in US dollars which were created at
very low cost. But, the US sends foreigners
less goods, services, and financial assets in return.
The difference is that part of the US
merchandise trade deficit held by foreigners as
US dollars (paper money, coins, and US bank
demand deposits) and used as a medium of
exchange. This is a temporary gift from
foreigners to US consumers, or more accurately an
open-ended putable loan with a “negative
interest rate” equal in magnitude to US inflation.
If that magnitude gets too large or
foreigners expectations of it get too large, they will
switch
to other currencies as a medium of exchange.
To do this, they will buy US goods and services
with US dollars that the US cannot consume.
This reverses the beneficial seigniorage
of the past, which in turn, lowers the US
standard of living.
Foreigners spending US currency and demand
deposits in the US will not increase the US
money supply (since they are already counted
in the money supply). But it will create demand
pull on domestic prices, since it will be
chasing US goods and services instead of facilitating
foreigner-to-foreigner transactions.
Note, much of this foreign-circulating US
currency is paper money and coins (rather than
demand deposits). The Fed estimates $778
billion of currency is in circulation, but does
not have an accurate measure of this. About
90% of all $100 bills printed are sent to the
New York Federal Reserve bank, mostly for
shipment overseas. Several academic studies by
the Federal Reserve Board of Governors and
by private economic-policy research institutes
like The National Center for Policy Analysis
in Washington, DC, estimate foreign circulation
of paper money and coins at between 40% to
60% of the total. Whatever proportion of that
being spent in the U.S would raise the money
supply by 20% to 30% of that proportion.
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That adds to the inflationary pressures
explained above and points toward hyperinflation.
(9.) CONCLUSION
The US is facing the possibility of a
classic sever recession or depression, which is based
entirely on investor and consumer
expectations that there will be one. Such recession or
depression are self-accelerating and
self-fulfilling, and can only be diverted from their natural
and disastrous course by the widespread
expectation of decisive Government action. In
particular, the Government should make a
single dramatic presentation which convinces
the American people that it will not happen.
This means the public must be convinced that
more-than-sufficient actions will be taken
by all the relevant parts of Government, working
in unison, to prevent it.
This must be done before the next obvious
harbinger of depression becomes apparent: the
mass closing of retail stores across the US.
The everyday spectacle of familiar retail stores
out of business will greatly reinforce the
current consumer and investor panic, that is the
heart of the financial crisis, and will make
it far harder to dispel that panic. Such closings
are likely in the first quarter of 2009
since ocean shipping of dry raw materials has fallen off
sharply in the last six months and container
ship rates (mostly for finished goods) are starting
to plummet. Less raw material shipped to
producers in the second half of 2008
implies less finished goods shipped to
stores in 2009. This slowdown in raw-material shipping29
is working its way into finished-good
transport, as container ship rental prices
reached an all-time low in the third week of
December 2008 and unprecedented amounts of
container shipping are being laid up.30
This
suggests retail stores will do far worse in 2009
than even the record-low sales of November
and December 2008. The International Council
of Shopping Centers estimated that sales
fell 2% in each of those months (largest since records
were first kept in 1969), and that 148,000
US stores will close in 2008, which shrinks
the total by about 3%. The MasterCard
SpendingPulse unit reports record 5.5% and 8%
year-over-year drops in those months,
respectively. Absent immediate and decisive Government
action, retail stores will be faced with a
two-pronged disaster in 2009. Consumers
will purchase even less and stores will have
much smaller shipments of goods to sell. This
will further devastate both consumer and
investor confidence, which is the stuff that depressions
are made of.
The nine policy actions in Section (6.), and
perhaps others, should be woven into a carefully-
staged and researched presentation to the
public. As much effort should be committed
to that presentation as to the actions
announced. It needs to be a psychological turning
point for investors, employees, and
consumers. Such a turning point will solve the crisis.
29
The Baltic Dry Index
BALDRY is the price measure of containerized ocean freight,
produced by The Baltic Exchange in
London. It fell 93.2% from 11,648 to 784
between 22 May to 22 December 2008. The ConTex index,
produced by The
Hamburg Ship Brokers Association, fell from
974 in May 2008 to 371 in the third week of December 2008.
30
On 22 December 2008,
Bruce Barnard reported in the The Journal of Commerce Online
that container-ship charter
prices (adjusted for inflation) reached an
all-time low. Rental of a 3,500 TEU gearless Panamax
(container) carrier dropped
from $25,000/day to $15,000/day just in the
third week of December 2008, and rental of a 2,750 TEU sub-Pananmax
(container)
carrier fell from $19,500/day in September
2008 to $10,500/day in December 2008.
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