...Archive for February 2008

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.