Which kind of credit crisis?

Note: Reading through, this post is unintentionally reminiscent of a much better column by Brad DeLong.

Yesterday I was flabbergasted by a small thing. I came upon this article on Morningstar. The piece, targeted towards potential investors, was called Munis Today: Lots of Yield, without All the Risk. It was chirpishly positive about munis and municipal bonds funds. You might think, given current circumstances, that there’d be some discussion of the monoline insurance crisis and the auction rate securities lockup. Here’s what there is:

By contrast [to corporate bonds], it’s a safe bet that in 10 years, the commonwealth of Virginia–which Fitch rates AAA–will still be free to collect taxes to meet debt and principal payments on general-obligation bonds maturing in June 2018. And across the nation, munis are often insured (the issuer buys default insurance from a handful of AAA rated insurance agencies) or prerefunded (meaning they’re backed by U.S. Treasuries). In fact, according to S&P data, about 67% of munis rated BBB or higher fall into one of these two categories.

As analyst David Kathman wrote in this recent article, bond insurers’ recent issues have thus far weighed primarily (though not exclusively) on the equity funds that own these insurers’ stocks, rather than on the municipal bonds they insure.

Morningstar is a big name. In their own words, “Morningstar is a trusted source for insightful information… Our ‘investors come first’ approach to our business has led to a strong reputation for independence and objectivity.” Really. You’d never know from this piece that several of that “handful of AAA rated insurance companies” have already had their ratings downgraded, that the entire sophisticated financial community is breathlessly fixated by the drama surrounding the rest, that those “AAA” firms have to pay worse-than-junk-bond rates on their own debt issues, and that for months insured bonds as a class have been losing value relative to “natural” AAA munis, approaching the value of comparable debt with no insurance at all. Still, I suppose it’s true that the “recent issues” have “weighed primarily (though not exclusively)” on bond insurer equity, as monoline shares have lost roughly 80% of their value since September, and insured munis have not. The author is misleading without quite lying.

That’s from Morningstar, a firm whose sole raison d’etre is to provide independent advice to investors. We’ve had the rating agencies taking huge fees and slapping their AAA gold standards on complex, untested products that quickly collapsed. We’ve had household names like Citi in trouble for off-balance sheet schemes eerily reminiscent of the Enron scandal. Now tell me, is it any wonder we have a credit crisis? Who would you trust?

The word “credit” comes from the Latin for faith or belief. A “credit crisis” is nothing more or less than a widespread loss of confidence in people or institutions whom we were accustomed to considering trustworthy. This is obvious, but it has implications. Right off, one can imagine two sorts of credit crises. The first, which we’ll call a “panic”, refers to an unreasonable loss of confidence in people or institutions that are fundamentally sound. The second we’ll call a “reckoning”. A reckoning occurs when there is widespread recognition that institutions heretofore deemed reliable are, in fact, not.

The policy implications of these two sorts of crisis are diametrically opposed. In a panic, government liquidity supports and even well-designed “bailouts” are entirely appropriate. When panic subsides, “mark-to-market” losses reverse, and liquidity supports can be removed. “Bailouts” end up costing taxpayers very little, and perhaps even turn a profit for the fisc, as government guarantees expire unused while taxpayers gain from appreciation of assets purchased by the government at a discount.

But in a reckoning, bailouts are dangerous. “Temporary” liquidity supports turn permanent, government guarantees crystallize into taxpayer liabilities, and assets purchased by government continue to lose value. As real wealth is channeled, either via taxation or inflation, from the population generally to the original cohort of unreliable actors, government itself becomes another institution which people reasonably come to consider untrustworthy. In a reckoning, better policy is to let institutions fail. If there are institutions that are too big to fail, they should be allowed to the brink and then nationalized, with equityholders wiped out and other obligations only selectively honored, in order to minimize external costs to the public rather than to satisfy unwise counterparties. (Obviously, this sort of discretion is a magnet for corruption. But paying off all claimants from public funds is corruption by default, and terrible precedent to boot. A reckoning is a bad situation in which quality of government matters, a lot.)

In a reckoning, the overriding policy goal ought not be to restore faith in discredited institutions, but to place firewalls between them and anything worth saving, and, most importantly, to encourage the formation of new institutions worthy of the public’s trust. That’s not as easy as cutting checks to incumbents, and it’s not a matter of “more” vs. “less” regulation. Building a better financial system from the ashes of a broken one is a project for which there are no cut-out recipes, whose inputs cannot be tallied as one-dimensional quantities, and whose results might look different from what we are accustomed to. But it’s not an impossible task, and it may well be unavoidable. A friend of mine, a pilot among other things, once related me the advice of his flying instructor: “The plane is going to land. The only question is whether you are still going to be flying it when it does.” In a reckoning, that’s advice that governments ought take to heart.

Which kind of credit crisis is the current one, a panic or a reckoning? Is the American economy, the US financial system “fundamentally sound”? Is Wall Street, with its current regulatory and institutional structure, worthy of the investors’ trust and simply going through a rough patch? Or has the financial sector failed in a deeper way, either because of uncontrolled “agency costs”, or because it is unable to fulfill its core mission, directing capital to opportunities whose long-term return is sufficient to provide both investors and financiers adequate compensation? What do you think?

Update History:
  • 24-Feb-2008, 12:20 a.m. EST: Added a missing “to”, removed some unnecessary scare quotes, reorganized a link so it highlights less text.

Market manipulation: Which is easier to game, issues or indices?

Generally speaking, the Ben-Stein-o-sphere is one corner of the financial internet from which I’m delighted to absent myself. Yves Smith is more courageous than I am in that regard, and while strolling the mean streets, he offers the following conjecture:

It is one thing to move the prices of single securities, quite another to move entire markets, particularly ones as big as the global equity markets and the US credit markets. We must have a simply staggering number of traders all conspiring together.

That’s a perfectly commonsensical thing to say. But is it true? I don’t know, but I think it’s a fascinating question. Here’s the pro and con as I see it:

Pro: By analogy with price impact behavior on individual securities, market indices should be well-nigh impossible to move. Generally speaking, the price impact of transactions is inversely related to the dollar trading volume of the traded issue and positively related to its volatility. It’s much easier to move a thinly traded small-cap whose value has recently ranged all over the map than to move, say GE. Broad indices are by definition diversified (which reduces volatility), and the dollar trading volume of index components is gargantuan. Ergo, it should be very difficult to move indices.

Con: Perhaps the analogy between indices and issues is misleading. Indices can be traded as though they were single issues, via ETFs and futures, for example. But the market for such instruments is fragmented, and trading in any one is orders of magnitude thinner than the volume of the overall market it mimcs. An ETF or index future would be hard to move not so much by virtue of its own depth, but because it is bound by arbitrage to the price of the market as a whole. But the market as a whole has a great many degrees of freedom, and many stocks whose “true” values are uncertain. If one wants to materially move the price of a single issue, one probably has to push against “informed valuation” by investors who specialize in the stock’s industry and are willing to take bets on relative pricing. But if one pushes against a whole index, arbitrage constraints can be resolved my moving many stocks only slightly, each issue remaining within the bounds of what would be considered noise by those who might trade a deeper mispricing. There’s an elegance to this approach, in that the market itself determines an optimal path to resolve the disconnect created by the manipulator. Stocks for which there is a great deal of valuation uncertainty would move more than those whose prospects are clear, and the market manipulator avoids the transaction costs of trading these tens or hundreds of relatively illiquid issues herself. (Price-weighted or equal-weighted indices would be more vulnerable than value-weighted indices to this sort of attack, as smaller / less liquid / more volatile stocks have disproportionate sway.)

That’s a nice theory, but would it work? I have no idea. If anyone out there has any insight into the question, hypothetically speaking of course, please do comment. It is frequently suggested that, while individual stock prices may be manipulable in the short-term, broad markets are immune. Is that right?

The “Fed put” in action

Felix Salmon writes, regarding this morning’s heroic 75 bp rate cut:

Does this mean that all the talk of “Helicopter Ben” and the “Bernanke put” was justified all along? Well, yes… There’s one reason and one reason only that the Fed took this move, and it’s the plunge in global stock markets on Monday, along with indications that the US markets were set to follow suit…. [T]his action smells a bit like panic to me, and it might also have prevented the kind of stomach-lurching selling which could conceivably have marked a market bottom. I have to say I don’t like it.

James Hamiltion responds:

I doubt very much that anyone on the FOMC has much interest in protecting the investments of stock market participants. Instead, I suspect that the Fed is using equity prices just as I and many other economic analysts do, namely, as a useful aggregator of private and public information about near-term prospects for economic growth. All the recent indicators have suggested a significant deterioration of real economic activity over the last two months. I take the global stock market sell-off as one more confirmation of that assessment, and new information about the global scope of the problems we face.

Hamiltion’s interpretation is charitable, too charitable to fit the evidence. If the Fed were only using world equity prices as an indicator, and were not specifically concerned with altering US stock market outcomes on this day, Tuesday, January 22, 2007, they would not have scrambled over a holiday weekend, perhaps over a single long night, to put together a virtual FOMC meeting prior to market open on a cold, tired winter morning. Nor is this the first time the Bernanke Fed has behaved this way. By my count this is the third unexpected pre-market announcement issued by the Bernanke Fed following indications of turmoil in equity markets. [1]

Let’s recall what William Poole, President of FRB St Louis (and, interestingly, the only dissenter to this morning’s move) said in November, 2007 about the “Fed put”:

I can state my conclusion compactly: There is a sense in which a Fed put does exist. However, those who believe that the Fed put reflects unwise monetary policy misunderstand the responsibilities of a central bank. The basic argument is very simple: A monetary policy that stabilizes the price level and the real economy cannot create moral hazard because there is no hazard, moral or otherwise. Nor does monetary policy action designed to prevent a financial upset from cascading into financial crisis create moral hazard. Finally, the notion that the Fed responds to stock market declines per se, independent of the relationship of such declines to achievement of the Fed’s dual mandate in the Federal Reserve Act, is not supported by evidence from decades of monetary history.

Poole is quite clear that he believes it is within the Fed’s mandate to use monetary policy “to prevent a financial upset from cascading into financial crisis”. That’s a plausible view of what the Fed is after with its surprise, early morning interventions.

Poole goes on to say…

From time to time, to be sure, Fed action to stabilize the economy—to cushion recession or deal with a systemic financial crisis—will have the effect of pushing up stock prices. That effect is part of the transmission mechanism through which monetary policy affects the economy. However, it is a fundamental misreading of monetary policy to believe that the stock market per se is an objective of policy. It is also a mistake to believe that a policy action that is desirable to help stabilize the economy should not be taken because it will also tend to increase stock prices.

Reviewing these two snippets reveals what I think are fatal tensions in the Fed’s practice of asymmetric macroeconomic stabilization (stimulate busts but never prejudge a boom a bubble). Poole is at pains, throughout his talk (whose theme is moral hazard) to claim that stabilization policy uses the stock market as a instrument of policy, but that this does not imply that the stock market can use the FRB as a backstop or guarantee. In the question of who’s using who, Poole wants to make it clear that the FRB is the boss. But, if the Fed must intervene to prevent “panics”, it has placed itself in the role of a parent habitually blackmailed by a self-destructive adolescent. “If you don’t give me what I want want Mommy, I’ll cut myself and maybe I’ll die!” As too many parents know, it’s a bad situation, precisely because the threat of harm can be credible. One can’t condemn a parent for capitulating in any particular squabble. But, it’s also obvious that this is a bad dynamic, one that shouldn’t be lauded as the cutting edge of “intelligent macrofamilial stabilization policy.” It’s not a particular policy action that’s bad, it’s the macroeconomic game that we’ve settled into that has to be changed if we want markets that aggregate external information and make wise allocation decisions rather than focusing on intrafinancial Kremlinology.

I’m not optimistic that the current Fed will transcend heroics and push towards a new dynamic. The Great Depression haunts the Fed chairman like the memory of an older sibling’s suicide. The troubled younger child will be coddled and indulged, and fingers will be wagged only when it is very safe to do so. But, tragically, indulgence and capitulation don’t always work, what appears to be the least risky course can sometimes be a sure route to escalation and destruction. When the last child died, it was blamed on tough love. But that might not be right, or if it was, it might say little about what this child needs.

Anyway, I think recent events have shown pretty clearly that a Fed put does exist. The Fed can be counted on quite specifically to try to forestall extreme lower tail outcomes on very short period US equity returns. That doesn’t mean the Fed is setting a floor under long-term asset prices. They might soberly stand aside as markets fall by 60% over a period of months. But they don’t want it to happen in a day. Long-term, buy-and-hold investors should take little comfort. But short-horizon traders have every reason to truncate the lower tails of the subjective probability distributions that guide their moves.

Still, though Bernanke & Co may fully intend to try, there’s no guarantee that the Fed will succeed at preventing sharp drops or sudden stops. The Fed is doing its best to offer traders a put, but as markets are now learning, counterparty risk can be a bitch.

[1] The first surprise intervention was the announcement on August 17 of the cut in the discount window spread from 100 to 50 bps following an overnight crash on Asian markets. The second was the Fed’s announcement of the TAF and central bank coordination on December 12, following a disappointed reaction in equity markets to a fed funds cut of “only” 25 bps. The third intervention was today’s. The timing of the Dec 12 announcement may have been a coincidence not much related to equity prices behavior, but the Jan 22 and Aug 17 announcements were, in my opinion, clearly intended to affect US stock markets.

Eliminate the business interest tax deduction

I was reading Greg Mankiw dissing a tax increase proposal by Hillary Clinton, and I thought to myself, “If I could invent a tax increase for Greg Mankiw to dis, what would it be?” Suddenly, the screen began to waver, dreamy harp music chimed, and a vision appeared to me on a tablet of balance sheets: Eliminate the tax deductibility of interest payments by businesses. Debt financing externalizes the risks of business activity and magnifies social costs, while equity financing concentrates risk among stockholders who signed up to bear it. Yet under current rules, taxpayers literally pay firms to get rid of stockholders and take on ever more debt.

Here’s the case-in-brief:

Creditors (people who lend to a firm) and equityholders (those who own stock) are fundamentally the same thing. Both are just investors, people who place money in the hands of a firm in hopes of getting it back later on, with a little something extra for their troubles. Whether one chooses to invest as a stockholder or bondholder is an idiosyncratic matter. Bondholders sacrifice potential upside for predictability and a legal right to enforce payments. Equityholders have no guaranteed payment schedule, but retain a potentially unlimited claim on a firm’s future success. Firms pay bondholders according to a predetermined payment schedule, interest and principle. Equityholders are paid via dividends or share buybacks, but only when management is confident it has sufficient resources to pay debt obligations and fund firm operations. For those who grew up in the era of structured finanace, the equityholder/bondholder distinction is basically a primitive version of the tranching you’d find in a CDO. (There is the control thing that, as a historical quirk, usually goes exclusively to equityholders, but we’ll put that aside for now. Creditors “own” a company as much as shareholders do, though the two groups have different sorts of rights associated with their claims.)

You’d think that the organization of investment contracts would be a private matter between people with money and people with good ideas about how to use it. But, that’s not the case. Large-scale investment is crucial to a modern economy, and getting investors to trust strangers enough to give them their money is hard. So pretty much every government takes an interest in helping things out. Governments define forms of business organization, enforce accounting standards, and develop a body of law that mediates between managers and the various classes of investor. To overcome some of the trust issues, the most nervous sort of investor, bondholders, are given the business equivalent of a doomsday device to enforce their claim on timely payments. If, of malice or misfortune, a firm fails to pay out as promised, bondholders can force a firm into bankruptcy and coercively try to recover what they’re owed. Though bankruptcy may be in bondholders’ interest, it is quite traumatic for other firm stakeholders. There are two facts we should take note of: 1) bondholders owe an especial debt to the state, as the state, often at great cost, much more aggressively enforces creditors’ rights than the rights of other investors; and 2) from a systemic perspective, a great predominance of bondholders — too much debt financing — is dangerous.

When an equity-funded firm underperforms, that mostly is a private matter that harms stockholders who knew the risks they were signing onto. When a debt-funded firm underperforms and cannot meet its obligations to bondholders, a sharp “nonlinearity” is provoked that frequently results in widespread harm to a firm’s employees, suppliers, customers, and the communities in which it operates. If debt financing is very prevalent within the firm’s “ecosystem”, one firm’s bankruptcy may cascade into widespread, even systemic, crises. Fundamentally, the right of bondholders to enforce their claims via bankruptcy is analogous to limited liability for investors of all classes — it’s a legal convention we’ve developed to encourage socially useful risk-taking that partially externalizes the downside risks for some investors. While equity-funded firms fail as well, they have more leeway to temporarily underperform and recover, and the impact on firm stakeholders is usually more gradual and predictable.

Don’t get me wrong. The existence of enforceable debt financing is a very good thing. It’s an essential element of the constellation of institutions by which we are able to fund large-scale capital-intensive projects without coercion. But, the public incurs costs and risks by promising to enforce debt contracts. If a project is going to be funded regardless, any state meddling in capital structure ought to tilt the scales towards equity rather than debt financing.

But that’s not what happens. Instead, corporate tax law strongly favors debt financing. One way or another, firms have to pay their investors. When firms pay stockholders, every dollar an investor receives drops off the firm’s balance sheet. But when a bondholder receives the same dollar, a US firm pays as little as 65¢. The other 35¢ is paid for by Uncle Sam, in the form of a tax deduction. This creates a great incentive for firms to buyback shares and borrow money, that is to convert from equity financing to debt financing, when times are good and thoughts of bankruptcy seem remote. For example, here’s Brad Setser, writing today about how the world looked one year ago:

There was no real risk to taking on more debt to reduce the amount of outstanding equity on a firms balance sheet and, in the process, increase the return on existing equity. Private equity firms had shown the way to arbitrage the difference between the pricing of debt and equity; all that remained was for everyone else to follow suit.

According to canonical financial theory a firm’s debt/equity split, or “capital structure”, should have no effect on overall firm value. It’s just different ways of slicing up the same money pie, in a common metaphor. But if you introduce tax deductions for debt payments, the equation changes. Then the theory predicts that a rational firm should load up on debt financing, in order to capture the benefit of the “interest tax shelter”. If bankruptcy were not an issue, rational firms would move to ~100% debt financing in order to extract the largest possible subsidy. With bankruptcy a possibility, a rational firm loads up on debt until the marginal increase in bankruptcy risk outweighs the marginal benefit of the subsidy. But if imperfect managers underestimate bankruptcy risk during periods of stability, they may unwittingly (or purposefully, if there are agency problems) bring firms close to the brink, provoking traumatic failures when the gales of an untamed business cycle blow strong and hard. By covering a large fraction of corporate interest payments, the government effectively subsidizes financial risk-taking that serves no operational purpose but generates real social costs.

So, here’s my proposal: Put payments to stockholders and payments to bondholders on a level playing field. Eliminate the tax deduction for business interest payments. I’m not sure how much extra revenue this would net the Treasury, but by ending a perverse incentive for firms and eliminating a large subsidy to the wizards of debt, it would pay off hugely in the form of a more stable corporate and financial environment.

Note: Another way to level the playing field between debt and equity financing would be to eliminate corporate taxation entirely. I’d be cool with that too, as long as it was accompanied by a tax increase elsewhere whose incidence is at least as progressive as the corporate tax. Actually, eliminating the corporate income tax while making up the difference with a surge in top income tax brackets would be a fine stealth bailout for stock markets, funded by really rich people. Stocks would instantly be more valuable! And really, if we are going to socialize the costs of our financial meltdown, shouldn’t we socialize it disproportionately to the people who gave it to us?

Fix the system? Blame the bankers? Same difference.

I really dig Andrew Clavell. But he is misguided in his criticism of an excellent piece by Martin Wolf.

Here’s Andrew:

[I]ndividual mortgage borrowers demanded their chance to improve their social and financial standing with scant regard for the potential consequences of their actions. MBS Investors (read hedge funds, money market funds, pensions, mutual funds as well as banks) demanded ‘attractive’ yields for the perceived risk, and had incentive structures and abundant liquidity available to encourage risk taking.

Mortgage borrowers and mortgage-asset investors were both long housing assets, the former with a call option on the upside, the latter by shorting puts on the downside for yield premium. Investment banks, at whose doors Mr Wolf et al are laying the blame for the outcome of this misguided speculation, just saw an opportunity to intermediate this activity and did so successfully. It was their own badly conceived warehousing of some of the assets which is causing them so much mark to market pain at present, but that is not the issue.

Are we supposed to blame the bankers for being oil in the cogs in the capitalist engine? Are we suggesting that banks should have desisted as they knew a bubble was developing? Why are we ready to pronounce them the bad-guys again? Purely since their pay is the most public and the most despised by outsiders. So let’s regulate it. Claw it back. Withhold it for 10 years.

Never mind that politicians and central bankers set the tone for investors (loosely, the American dream). They don’t get paid much, so let’s not blame them. Let’s also not claw back their salaries or appropriate large fractions of their fees from lucrative speaking tours or book sales following their exit from public duty.

Never mind that the majority of ordinary people are illogically risk seeking in housing markets, or dot com shares. Ordinary people don’t get paid like bankers, so let’s not blame them. Let’s not try to educate ourselves properly about finance before we wreak such destruction.

Never mind all that. Blame the intermediary who earned too much.

Andrew is quite right to note that there is plenty of blame to go around. Ordinary folk herded into scam mortgages, taking a rational bet that this year would be like last year and they could catapult themselves into the upper middle class by taking a chance on the biggest home they couldn’t afford. Institutional managers herded into structured products promising high yield at next to no risk, products that seemed to violate the most elementary rule of finance (no arbitrage), and were shocked, shocked when after four years of great bonuses, their clients learned there was risk after all. And bankers of all ilks and alphabets, I-bankers, C-bankers, M-bankers, discovered there was great money to be made, intermediating (originate and sell!), dealmaking (LBOs, baby, it’s a new era of infinite leverage and no defaults!), and shoving risks where stockholders and regulators couldn’t see them (SIVs are just innovative!). People who face opportunities with stratospheric upsides and largely externalized downside costs take chances. Fundamentally, the behavior of bankers was no different than that of homebuyers with dollar signs in their eyes, the guy who ran a “mortgage company” from an e-mail server in his basement, or you and me in their situation. So, why should we pick on them?

We should pick on them. It’s not because they’re bad people. Most bankers are very nice people. We should pick on them because, as Andrew says, banks intermediate. They are a point where all the lunatics meet to transact, a point where applying pressure can change everything. We can rant and rail against human nature, but who cares? People is people, God bless ‘em. But banks are formal institutions, amenable to laws, regulations, and litigable norms and standards that are easily reshaped. We don’t have to throw up our hands at frailty and corruption and watch reruns from the 1930s over and over again. We can actually mess with banks (and other financial intermediaries) in ways that indirectly shape the behavior of the rest of us (and that are not terribly intrusive to most of us). It simply isn’t true, in the general case, that human desires are exogenous and “demand will find supply”. The explosion of misbehavior on all sides of the credit market over the past several years was not caused by a burst of theta-waves from the Earth’s core. We allowed our institutions to evolve to a place where misbehavior was ordinary, caution uncompetitive, prudence a firing offense. If we change the institutions, we change the behavior. We can do that, and we should do that.

I’m skeptical of proposals (by Wolf and others) with regard to bankers’ pay, not because they are harsh, but because they are circumventable. Escrowed cash and restricted stock can be pledged and hedged, regardless of formal prohibitions. (We simply haven’t invented a decent compensation instrument that can’t be cashed out. That would be a profoundly useful financial innovation.)

Unsurprisingly, when Martin Wolf and Andrew Clavell agree, it’s worth paying attention. Wolf:

An alternative suggestion is “narrow banking” combined with an unregulated (and unprotected) financial system. Narrow banks would invest in government securities, run the payment system and offer safe deposits to the public.

Wolf backs off of this suggestion far too quickly. (“The drawback of this ostensibly attractive idea is obvious: what is unregulated is likely to turn out to be dangerous, whereupon governments would be dragged back into the mess.”) Much of this danger could be ameliorated with one parsimonious regulatory principle for the nonbank financial sector — An absolute prohibition on scale. There should be hard limits on the quantity of gross assets under any one entity’s control, combined with strong norms of independence (copycat investing is prima facie poor practice that opens up managers to investor lawsuits), along with antitrust like scrutiny of coordinated action. This would represent a big change. The current legal environment creates artificial economies of scale (the complexity of securities law), rewards herding (“safe harbor” provisions, “Nationally Recognized Statistical Rating Organizations”) and punishes independence (managers who make unusual choices face investor liability). The maximum permissible size should be absurdly small by today’s standards.

Obviously, this is a radical proposal, unlikely to happen anytime soon. But we may yet get to the point where all our choices are scary, so we’d best have some good options ready to go, just in case. One way or another, we have got to improve a financial sector that extracts a large fraction of collective wealth, allocates capital poorly, and creates periodic bouts of instability and human misery. Most of the men and women who work on Wall Street are fine people. But in Manhattan as much as in Michigan, broken institutions ought not be protected from bouts of creative destruction. America’s vaunted financial system does not adequately serve the purposes it is meant to serve. That has to change. Ideally, we should encourage private innovation and follow a cautious, incremental path to something better. But regardless of how we get there, a lot of people who have been well compensated under existing arrangements aren’t going to like the changes. Too bad.

Link Lovin’ fer the New Year

I decided long ago not to have a “blogroll”, figuring that I would naturally link to the people I read. But it hasn’t really worked out that way. There are lots of amazing authors whose every word I hang on, but whom I rarely have occasion to link. This interweb is an amazing thing. Banks may implode and currencies morph to toilet paper, but intellectually, these are the best of times. There has never been a conversation like this, so many wonderful minds communicating in a forum that is open to everyone, but still relevant, even influentual. Thank goodness for this crazy machine, and for all its cogs and pulleys — writers, commenters, and especially readers.

I want to devote my first post of the year to highlighting and thanking some of the people whose words keep my brain pleasantly marinated. [A note about names — I’m a first-name-basis kind of guy, and will thank accordingly. My use of first names implies neither disrespect of nor any personal familiarity with any of the thankees.]

If I had to nominate one blogger for the role of “hero”, it would be Brad Setser. For years now, Brad has been painstakingly documenting the financial backstory of our times. Bubbles pop, this hedge fund fails, that central bank acts, blah blah blah. Every day another headline, but Brad has focused on the slow grinding of plates beneath, invisible to most but actually the source of the tremors. He approaches the task with a Sisyphean work-ethic, remarkable civility, and openness to new ideas and especially new data. (Brad’s comment section also merits note. It is, I think, the best on the web, thanks largely to the caliber of the headline posts, and Brad’s willingness to engage all comers as colleagues.)

Mark Thoma is a different kind of hero. Economist’s View is the New York Times of the econoblogosphere, the place to find the news of the day treated at length and seriously. Like the Times, there is more reportage than editorial, but the quality of the Mark’s editorial is consistently higher than the Times‘.

Within the ghetto of finance, the first place I turn to for my fix of news is Felix Salmon. I’ve been a Felix fan since he first started scribing as RGE‘s original Economonitor. (They were fools not to have offered thrice whatever it would have taken to retain him there.) I owe Felix a special debt, as he was the first widely read blogger to deem my ravings here linkworthy. It’s been less lonesome ever since. I do have a complaint, though. Back in the day, Felix was the first and only finance blogger who consistently had me spitting up Fruity Pebbles onto my PowerBook. He was hilarious, sometimes hilariously mean, to all comers (including, very gratefully, yours truly). Ever since the snooty Condé Nast franchise got him, he’s been so well behaved. The thoughtfulness, range, and quality of content on Market Movers is better than ever, but I do miss having to replace expensive hardware following a particularly artful post.

Calculated Risk and Tanta have done an amazing job at explaining the housing bubble and the mortgage industry, with clarity, depth, and panache. Yves Smith at Naked Capitalism weaves anthology and editorial, keeping us abreast of the intricacies of the financial world and offering a useful perspective from which to view those goings on. I have occasionally linked Yves to disagree with him, but that’s the exception that overwhelms the rule. Yves is usually right, and always worth listening to. Another person who is usually right and deserves special mention for it is Dean Baker.

If you are interested in finance, and don’t read jck at Alea, you’re unserious. jck reads widely and obscurely and unearths some real gems. His posts are often deceptive in their brevity. jck has mastered that art of packing tart commentary and a pair of X-ray spectacles into a couple of sentences, sometimes just in the highlighting. Another underappreciated master of concision is Scurvon. Scurvon comments with a wide and eclectic range in a style that’s straight, direct, and brief. It’s like intravenous information, and you can’t even feel the needle going in. Of course, the most concise bloggers of all are those who only link, and among finance bloggers, Abnormal Returns does a great job of that, except for a few lapses in judgment and taste (he has linked Interfluidity).

Interfluidity, unfortunately, belongs to the subgenre of finance blogs that might be referred to as the we-are-so-fucked-o-sphere. The demigods of our happy realm would have to be Micheal Panzner and Nouriel Roubini. Michael was kind enough to mail me a copy of his book, Financial Armageddon. Michael’s baseline scenario (he often writes in the simple future tense, rather than any hedging with any conditional) is so dark that most of us doomsayers seem like Pollyannas by comparison. The book is worth reading, and the blog carefully documents a world slowly waking up to how bad a fix it has got itself into. Other excellent members of our dingy neighborhood include Michael Shedlock and Aaron Krowne.

Just about one year ago, I got into a lengthy comment debate with one moldbug, whom I first encountered as a commenter on Brad Setser’s blog. moldbug is a wonderful writer, an unusual intellect, and a sharp cookie on all things monetary. We have divergent views about what money ought to be, but similar views of the problems we face now, and he was delightful to argue with. He now has his own blog, Unqualified Reservations (although much of his best financial writing remains where it began, in Brad’s comments).

In no particular order, other finance blogs that I read pretty much constantly, and to whose authors I am grateful, include The Big Picture, Accrued Interest, Financial Crookery, Credit Slips, Cassandra Does Tokyo, Jeff Matthews Is Not Making This Up, The Mess That Greenspan Made, as well as (with a hat tip to Brad Setser) Macro Man and Michael Pettis.

Of course, finance is just one distateful ghetto in the odd, misshapen galaxy of economics. Liking to think of myself as a worldy galaxyly person, I read the economists as well. All this link lovin’ is leaving my fingers sore (don’t go there), so I hope the following authors will understand themselves to be worshipped and adored, despite being so perfunctorily listed: James Hamilton and Menzie Chinn, Brad DeLong, Tyler Cowen and Alex Tabarrok, Dani Rodrik, Thomas Polley, William Polley, Robert Vienneau, Robert Waldmann, George Borjas, Paul Krugman, Gabriel Mihalache, Greg Mankiw, Jonathon Dingel, and knzn .

Of course, there are a hundred, a thousand, a million people, links, stars I’ve missed. The stars in this galaxy, and in other galaxies near or far, are so numerous as to be grains of sand. The texture of the world is not made of isolated points, however many you might catalog, but by the fact that there is somewhere everywhere, a spark in every crevice. (No, that is not why my fingers are hurting.) To all those I’ve named, and those I’ve unforgivably forgotten, and those I don’t even know but might find with a click, thank you for this amazing conversation. To be a small voice in this cacaphony, in this harmony, is a great privilege.

And thank you, whoever you are, who takes the time to read these words. I am blessed by the company of your eyeballs, as creepy as that sounds. (Don’t worry. I’m not hungry.)

Update History:
  • 06-Jan-2008, 5:31 a.m. EST: Let the unforgivable omissions guilt begin! Added knzn, whom I mysteriously missed in my first perusal of my well-worn feeds.
  • 06-Jan-2008, 3:34 p.m. EST: Restored a missing ‘n’ to Michael Panzner’s name.
  • 07-Jan-2008, 3:28 p.m. EST: Fixed the name of moldbug’s blog, “Unqualified Reservations”, not “Unqualified Offerings”. Thanks to commenter nadezhda, who recommends the original Unqualified Offerings. And also to commenter Independent Accountant.
  • 08-Jan-2008, 2:52 a.m. EST: Removed an excess ‘l’ from the end of Jonathon Dingel’s name. Sorry to all — this was truly a masterpiece of typos.

When a rose is not a rose: TAF is not “just” the discount window

Yves Smith at Naked Capitalism and Accrued Interest have both taken very measured views of the Fed’s new Term Auction Facility, which gets its big start on Monday. As Smith puts it, TAF is the “discount window with no stigma and another pricing mechanism”. He also notes that the Fed’s novel device looks just like the same old auctions the ECB has been using as a monetary policy tool for years, and observes pessimistically that “the gap between non-dollar Libor and the ECB’s target rate is higher than the spread between Libor and Fed funds. Not a good sign.” (Bloomberg reports that Friday’s markets shared Smith’s skepticism.) Accrued Interest, responding to my ravings, suggests that TAF is no more a “bail-out” than any other lending at the discount window.

Yves Smith and Accrued Interest are two of the finest financial bloggers out there. If you are dallying here without having read every word they’ve written, your priorities are out of whack. Nevertheless, both are missing a forest of difference among trees of similarity. To call TAF the discount window without the stigma is like calling a person a corpse that is not dead.

In theory, TAF and the discount window are quite similar. In practice, it never mattered what the discount window was, because it was so little used. TAF is the discount window remastered. It is designed to be used, in quantities heretofore inconceivable. James Hamiltion, in an excellent discussion of the facility, shows a graph of historical direct lending by the Fed. Thanks to TAF, the graph through December 2007 will show a spike so tall you’d need a screen three times as tall as a typical monitor just to accommodate. Prior to TAF, the Fed had no effective tool for getting funds to banks in trouble, since loans at the Federal Funds rate are only available to banks that other banks trust, and borrowing at the discount window is expensive, financially and reputationally. With TAF, the Fed can lend directly to the sketchiest banks, and on very generous terms, without spooking depositors. As the ECB’s experience suggests, this funding mechanism can made quite routine. Some commentators view TAF as a temporary means of addressing end-of-year liquidity issues, but I suspect that TAF will be an active part of the Fed’s monetary policy arsenal for the foreseeable future.

If TAF is so similar to the ECB’s facility, why should it matter? After all, the ECB hasn’t succeeded at calming European interbank markets, yet. But, in the words of the maestro (Eric Clapton), “It’s in the way that you use it.” In order to reduce interbank spreads, central banks have to (1) auction money in quantities sufficient to ensure that the “market price” is quite close to the interbank rate policymakers view as healthy; (2) accept a wide variety of bank assets as collateral, and place high valuations on those assets relative to the market bid; and (3) credibly signal that it is willing and able to continue these policies in perpetuity, or until the crisis is abated, whichever comes first. Point (1) immediately drops the cost of borrowing by troubled banks to “ordinary” levels. However, this alone will not immediately reduce spreads on loans are still made between banks. Private banks will still fear counterparty defaults even if the central bank is blasé. Interbank spreads might even widen, as lenders view failure to anticipate and secure adequate funding at auction as a sign of trouble. Point (2), over time, will remedy this. Easy lending against a broad panoply of assets helps ensure that banks have the capacity to bid for all the funding they need. At the same time (as Yves Smith was quick to point out), the price at which assets are accepted as collateral suggests a floor for accounting valuations, helping to assure counterparties that borrowers won’t be thrown into crisis by a sudden write-down. Again, the effect here won’t be immediate — as long as collateral values and market bids are divergent, there will be valuation uncertainty. But, that’s where point (3) comes into play. There’s an arbitrage between exchange value and long-maturity collateral value. If the traders view collateral values as stable, eventually market bids will rise to approach the central-bank set asset prices.

This medicine will take time to work. Central banks will have to establish credible expectations of continued support. Don’t expect “forward looking markets” to reprice spreads until central bankers establish a track record. The ECB is not auctioning enough money yet, but it will. I suspect that, despite Europe’s institutional head start, it will be Bernanke’s radical Fed that shows the way.

Many commentators view TAF as an odd, desperate attempt by the Fed to do something, or to seem to do something, in a desperate situation. That is not my view. I think the Fed is acting quite deliberately here, that it is working out of a playbook that the Chairman developed and described years ago. I am optimistic that the Fed’s approach, if pursued tenaciously, can succeed in undoing the widespread perception of risk and instability in the banking system.

Of course, “optimistic” is not quite the right word here, because I oppose the whole enterprise. All the talk about moral hazard and burning houses misses the point. The financial sector has underwritten gargantuan misallocations of real resources in the United States, and profited handsomely from doing so. The cost of these errors is not just a matter of homes foreclosed, or a period of commercial turbulence and unemployment. We face the prospect of a serious decline in living standards, increased danger of conflict between large powers (which hopefully, but not certainly, will be confined to the economic sphere), and the possibility of social instability of a kind we’ve not witnessed for decades. There are actors in this drama who “deserve” to be punished, under a nineteenth century view of moral hazard. But that is not why we should endure rather than resist a painful restructuring of the financial sector. If we could let bygones be bygones and move on, that’d be great. But the reason for institutional accountability in any setting is not to shame and punish, but to create the conditions under which future actors will not misbehave. Contra Nouriel Roubini, the real economy cannot be “bailed out”. It must be built and repaired via the wise application of present scarce goods and services, rather than salved with promises of future goods and services. We require a financial sector capable of aggregating widely dispersed information into wise choices regarding the use of present resources. We absolutely do not have such a financial sector right now. Which is why the very expensive financial sector that we do have should be let go.

Existing players, including the Fed, won’t see it this way. The Fed will lend to support collateral values at levels higher than conventional valuations would merit. They will work with financial institutions to roll over loans as necessary, even against decaying collateral, rebundling assets to maintain some veneer of plausibility when underlying cash flows develop poorly over time. The proud titans of Wall Street can and probably will be bailed out. The rest of us are not so lucky.

Update History:
  • 17-Dec-2007, 3:42 p.m. EST: Cleaned up / reworded third paragraph quite a bit.

Insolvency is philosophy, illiquidity is fact

Take a look at a snippet of GM’s last-quarter balance sheet (courtesy of Yahoo! Finance). It’s the part that contains what accountants quaintly call “Shareholder Equity”:

Yes, the accounting value of the firm’s equity is negative 41.7 billion dollars. Now, answer me this. Is GM insolvent?

There is no definitive answer. It’s a philosophical question, a matter of opinion. The market says GM’s equity is worth $15B dollars. All we can say with any confidence is that GM is liquid, it has not yet failed to pay its bills, it is capable of borrowing to finance its operational needs despite a balance sheet with no vital signs. The patient walks and breathes, so it is not dead. Somehow.

There is a meme going around the blogosphere, and now the mainstream-press-o-sphere, that the Fed is helpless in the current crisis because the problem is one of solvency, not liquidity. Here’s Paul Krugman (hat tip Mark Thoma):

In past financial crises… the Fed has been able to wave its magic wand and make market turmoil disappear. But this time the magic isn’t working… Why not? Because the problem with the markets isn’t just a lack of liquidity — there’s also a fundamental problem of solvency.

Here, here, Dr. Krugman. And you too, Dr. Roubini. And Michael Shedlock. And Kevin Drum. I agree with you all. From the tiny legal entities known as asset-backed securities, way up through to a couple of large money center banks, there are a lot of entities out there which, by my Victorian standards, are simply insolvent. But by those standards, GM oughtn’t be able to fog a mirror, let alone borrow money from people. It’s the living dead, a zombie, to use a term fashionable when discussing Japan but never, ever appropriate to the hypercapitalist U.S. of A.

Can a determined central bank “wave its magic wand” and make insolvent entities solvent? I have no idea. But I do know this. A central bank can keep almost anything liquid for a long, long time. And as far as financial markets are concerned, only liquidity matters. The little theory called solvency is only relevant to the degree that it predicts liquidity, or illiquidity. Central banks can undo that relationship, if they wish to. Perhaps they wish to.

I have no idea how “aggressive” the U.S. Federal Reserve will become in trying to resolve the present crisis in credit markets. There are in norms of accounting, regulatory frameworks, laws, that might constrain it. But, central bankers have been remarkably candid in describing their willingness to circumvent these constraints in a crisis. (See here or here for examples.) With the new Term Auction Facility, the US Fed has just given itself a tool by which it can ensure the liquidity of “insolvent” assets, at prices the bank itself determines, indefinitely. Some commentators (e.g. Yves Smith) have wondered how a temporary facility, loans with a fixed term of one month, can make much difference one way or another in the liquidity of assets. The answer, of course, is that they can be rolled over (via new auctions, which are already announced for January, or by other means). The same logic that impels the initial extension of credit suggests that loans will be rolled over, must be rolled over, for as long as “crisis” continues. The Fed has bent over backwards to help out financial institutions. Once it has direct loans to those institutions on its balance sheet, it will own their problems in a way it has not until now. Will the Fed pull the plug and demand payment of a bank that says it cannot pay? Will it force a bankruptcy, as private creditors might, if the bank was in default? Is that even conceivable? The day that happens to a bank of any scale is the day you can be sure the credit crisis is no more.

I’m going to end with a bit of a cheap shot, because really, nothing is beneath me. Remember this?

The aide said that guys like me were “in what we call the reality-based community,” which he defined as people who “believe that solutions emerge from your judicious study of discernible reality… That’s not the way the world really works anymore. We’re an empire now, and when we act, we create our own reality.”

Worrying about “insolvency” is a defect of the reality-based community. For everyone else, all that matters is the price at which assets can be sold or borrowed against. The Fed can set that price, if it acts with sufficient, um, determination. Analyzing underlying cash flows is for pansies.

The latest financial innovation cooked up by the banking system might be described as “postmodern pricing”, whereby the exchange/collateral value of assets is intentionally unmoored from quaint ideas like “true” or “fundamental” value. All for the benefit of struggling homeowners and hard-working ordinary Americans, of course. If you are among the macroeconomic mainstream that has nodded along with Fed interventions to support “liquidity”, but you find this brave new world troubling, well, good. Better late than never, and you are welcome among us. Expect to be mocked. Bear it with pride.

Update History:
  • 14-Dec-2007, 5:39 p.m. EST: Replaced the awkward “I want you to take a look at…” with just “Take a look at…”
  • 14-Dec-2007, 6:15 p.m. EST: Cleaned up some wordiness (unnecessary “thus far”), added some wordiness (“help” to “help out”), inserted a missing verb to be.

TAF is a really, really big deal

I haven’t time to write properly, I am caught between a million things. But when I woke up to the Federal Reserve’s press release about the TAF, my jaw dropped. It was one of those moments when the world shook, everything was the same, but everything had changed. So, when I step into the blogosphere to read comments like “solid first step“, I feel compelled to spew some first impressions.

  1. If you think (as I believe most Fed policymakers do) that the goal of monetary policy in reacting to the current financial crisis is to make it go away, this plan is brilliant.

  2. Under traditional discount window borrowing, the best the Fed could do is offer funds at a “penalty” or “premium” and hope that banks borrow, despite a longstanding market perception that direct borrowing from the Fed is a sign of weakness. Now, the Fed has turned the tables. It will set precisely how much money it will lend ($40B just in the next cople of weeks!), and let banks bid on how much they are willing to pay for the use of that money. The scale of this program is immense. Typically direct borrowings from the Fed are under $1B. It was a big deal in August when in a clearly orchestrated and coordinated move, 4 big banks were persuaded to temporarily borrow $2B total, in an attempt to diminish the “stigma”. This is the Federal Reserve saying, “No more pussyfooting around. You will borrow, and not $1 or $2 billion, but $40B, now!”

  3. I agree with several commentators (Felix Salmon, Calculated Risk) that the Bair/Paulson Plan, whatever it is, is not a bailout. But this, this is a bailout,. Nearly all government bailouts take the form of subsidized loans, extending credit at low rates to counterparties or against collateral for which the market would have demanded a high premium. That is precisely what the TAF will do. The Fed’s press release claims, of course, that loans will only be available to “sound” banks, and that they will be “fully collateralized”. But no one who can get the same deal from private markets will use this facility. The need for the program arises because private markets are skeptical about the soundness of counterparties and the quality of the assets they have to offer as collateral. The Fed hints at this when it mentions the “wide variety of collateral” that can be used to secure loans. You can bet that whatever it is private lenders are eschewing will be pledged as collateral to the Fed under TAF. The Fed is going to bear private risk that the market refuses to. That is a bailout.

  4. The rate at which funds are lent could turn out to be be an interesting number, but probably won’t. This rate will be bounded within a narrow range. It can’t go much lower than the expected Federal Funds rate over the term of the loan (there would otherwise be an arbitrage for very creditworthy banks — borrow TAF, lend Federal Funds). Presuming consistent standards for collateral and creditworthiness, it can’t go higher than the ordinary discount rate (since banks would just go to the discount window directly rather than bid in an overpriced TAF program). In theory, the TAF rate could tell us something about the state of the credit markets. If it is close to the Federal Funds rate, it would mean that few parties are experiencing problems borrowing cash against their assets, while if the TAF rate were near the discount rate, that would signal credit market, um, turbulence. But interpretation of this number is going to be made complicated by the scale of monies being offered. To lend 40B cash fast, the Fed may well have to offer the money at near the Federal Funds rate, because the particpation of very creditworthy banks will be required to get rid of the dough. But less creditworthy banks will be participating as well, and, in a single-price auction, these banks will enjoy the low interest rates effectively set by large-bank bidding. So, it is likely that the TAF rate will be very close to the expected Federal Funds rate, but that noncreditworthy borrowers pledging iffy collateral will gain the capacity to borrow at that rate. The effective discount window “penalty” will drop to about zero, even though the formal discount premium will stay at 50 bps.

There’s much more to say about all this. (Systemic implications? will it be effective against the crisis? what’s the role and meaning of the “global coordination” aspect to all this? etc., etc.) I have a meeting. Very blogospherically, I’m going to hit send and go without even a proofread. Please forgive my enthusiasm, and any errors that might come with.

Update: Of great significance to the workings of the international financial system… I’m Steve! A couple of very fine bloggers have linked to this post, referring to me as Randy. [Both fixed now! Thanks!] I include my middle name in my punditizing to distinguish myself from a more famous Steve Waldman who most emphatically is not me! Also, my last name has just one ‘n’, and I should not be confused with the much smarter and better looking Robert Waldmann, who is blessed with two letters ‘n’. Finally, I’d like to clarify a bit that my “enthusiasm” for the TAF plan, and my suggestion that it is “brilliant”, should be understood in very narrow terms. From the perspective of policymakers whose goal is to put out a fire while minimizing changes the existing structure, I do think the TAF is a stroke of brilliance, although it may lead to some hard choices down the line (more later). But I want to emphasize, that perspective is not my own. I believe that capital markets and the global financial system are in quite urgent need of reform. I don’t support palliative measures unless attached to credible reasons to believe that they will put us on a path to change, rather than extend a quite awful status quo. So I don’t “like” the Term Auction Facility. But I do admire its cleverness.

Update 2: Note Felix Salmon’s comments (with the help of Alea’s jck) on discount window collateral.

Update History:
  • 12-Dec-2007, 6:32 p.m. EST: Added two “update” paragraphs, moved scare-quotes from discount window to penalty, where they belong.
  • 12-Dec-2007, 7:25 p.m. EST: I’ve messed around with some wording and misspellings in the updates.
  • 12-Dec-2007, 11:10 p.m. EST: Added “Both fixed now. Thanks!” to the first update. Also, added a missing “the”, and replaced an extra “the” with a “to”.

Salmon vs. Salmon on the Bair/Paulson relief plan

The news du jour is a quickening of interest in an idea originally mooted by the FDIC’s Sheila Bair, now adopted by U.S. Treasury Secretary Henry Paulson, that would freeze resets wholesale for certain classes of struggling mortgages. The Victorians among us, cluck and tutt at, yes, the moral hazard and perverse incentives implied by this sort of plan. Fortunately, no one ever listens to us.

Elizabeth Warren offers up a combination of pragmatic and Victorian concerns, among which are that “lawsuits will fly thick and fast, enriching the lawyers and tangling up the homeowners.” Felix Salmon argues not, but he’s mistaken, and he himself explained why. Besides teasing Felix, understanding this issue sheds light on why this plan could be an important tool in resolving the current credit crunch. Big hint: It ain’t (primarily) about helping homeowners.

Here’s Felix, today:

Most loan modifications actually increase the total amount of money that the investors stand to receive. In this case, it’s conceivable that… bondholders might get a bit less money than they would otherwise. But that’s a really hard calculation to make, and unless you can make that calculation with some certainty, it’s going to be very hard for you to show damages. Let’s assume that an investor in an RMBS tranche can compellingly show losses of say 5 cents on the dollar as a result of the Paulson plan. (We’re talking about the difference, remember, between the present value of what that investor will now receive and the present value of what that investor would receive were the plan not in place.) Given the size of individual RMBS tranches, and the number of investors they were sold to, that investor probably has no more than about $20 million invested in the tranche. Which means that he’d be suing for $1 million. Not worth it… What if he put a class action together, and got all the owners of that tranche to sue? Well, maybe the tranche was $50 million in total. We’re still only talking $2.5 million in damages here.

Now, here’s Felix with the answer, on Friday:

In reality, it’s almost certain that some bondholders would benefit from this scheme, while others would lose out.

Suppose it is true that, on-average, cashflows to the whole class of affected securities changes very little under the workout, that the savings to investors from avoiding defaults roughly balances the cost of the reduced income stream. Consider what this workout does to the certainty of cashflows for any particular MBS pool. Prior to the workout, under a low-default scenario cashflows are very high, while under a high default scenario they are very low. In the “good case”, the senior tranches get paid, but so do the tranches a few levels down. In the bad case, the junior tranches lose everything, and the senior tranches lose some fraction of their value. For valuation purposes, the marginal junior tranches now resemble at-the-money call options, valuable when outcomes are volatile, worthless when they are certain.

And what would the Bair/Paulson plan do? It would increase the certainty of the cash flows, to a level where, on average, senior tranches would be made whole, but marginal tranches would lose out. In other words, even if the effect on total cashflows in the aggregate is very small, the Paulson plan would wipe out the option value of tranches at the margin. Holders of these tranches won’t take a 5% haircut, but a 100% haircut off the tranch’s current value. You betcha they’ll sue if they have any hope of relief. [*]

On the other hand, holders of senior debt will be made whole with much greater certainty. The proposal effectively represents a transfer of wealth from junior to senior trancheholders. Which gets us to its clever systemic implications.

The current credit crunch stems not from the absolute scale of writedowns, but from the distribution of the losses. Highly leveraged entities with very little capacity to bear risk, who thought they were holding “supersenior” (but yield enhanced!) securities, are facing catastrophic unexpected losses. If those losses could be shifted to investors with a greater capacity to bear risk, the systemic implications would diminish towards the absolute scale of the losses, that is, towards insignificance.

Less senior trancheholders are being asked to take a hit, because they can, to save other investors who can’t afford their losses. From each according to his ability, to each according to his need. You’ve gotta love capitalism.

[*] To understand this better, recall that the total world of securitized mortgages is divided into distinct pools, each of which (simplifying some) backs a security, which is then subdivided into tranches. Without the Bair/Paulson plan, some of these pools would do well enough to pay the senior tranches and a few junior tranches, while other pools would do poorly, wiping out the junior tranches and forcing the senior tranches to take a haircut. Under the proposal, all of our stylized-just-at-the-margin junior tranches get wiped out, while all the senior tranches are made whole. Prior to the payment streams actually developing, we can’t know which pools would pay-off junior tranches and which wouldn’t, so all these tranches currently have some value, like a lottery ticket. That value would be wiped out under the plan. Note that some junior-tranche investors may have done due-diligence on the quality of credits in the underlying pool (or relied exclusively upon unusually high-quality packagers), and these investors might expect with high probability that the “good scenario” would unfold. Under the Bair/Paulson scheme, these investors would be wiped out anyway, and therefore penalized for their efforts (due diligence is expensive), unless you believe that it’s possible (and equitable) for those executing the plan to separate those who can and can’t afford a reset with very high precision.

Update History:
  • 03-Dec-2007, 3:18 p.m. EST: Added update in second Felix quote…
  • 03-Dec-2007, 6:25 p.m. EST: Took out second sentence of second Felix quote, which is better.