When you're abducted by aliens, there's little cause to be cynical. The sucktitude of a painful probe is straightforward. There's no sugarcoating to see past, things are exactly as bad as they seem. Between the screams you realize that, in a way, you have been offered a kind of innocence. When you are abducted by aliens, you savor the silver linings.
After such an ordeal it's a bit depressing to be dropped off on the Planet of the Covered Bonds. Cynicism levels are off the tricorder here as, alas, they should be. [See Yves Smith, Michael Shedlock, Maxed Out Mama. Less cynically, David Merkel offers a very nice description of what covered bonds are and how they work.]
Covered bonds sound nifty. They're designer drugs. They're just like the mortgage-backed securities that gave us such a fine party, except the nasty hangover inducing components have been engineered away. They are on-balance sheet loans, look Ma, no Enron! (finally...) Covered bond issuers have "skin in the game", skin, bone, and sinew actually, as they guarantee the loans. That problem of "misaligned incentives" is solved, 'alleleujah! (...though intrafirm agency problems are not addressed.) These are old-fashioned, full recourse, secured and overcollateralized loans, just packaged into tradable securities. What could possibly go wrong?
Formally, the only way anything could go wrong would be if the issuing bank fails and the pledged assets turn out to be worth less than originally estimated. Do you think those two events might be correlated? Covered bonds can certainly be no worse, from an investor standpoint, than the nonrecourse asset pools they are intended to replace. A guarantee by the issuing bank has gotta be worth something. If it were 2002 again and the banking industry had adopted this originate and guarantee model (rather than the originate and forget model they chose), perhaps we wouldn't be in the current mess. But it is not 2002. These bonds will be offered by banks that would already have collapsed without vast support to the financial system by the Fed and the US Treasury. Guarantees by money-center banks are no longer bonds of confidence in the prudence or skill of bank managers. The value of such guarantees comes from a different place, from the notion that it is unthinkable the state would permit these banks to fail. A covered bond offered by Citi or Bank of America would only default if a titan collapsed. Investors might reasonably believe that would not be permitted to happen. If they are right, then these bonds are indeed covered. They are covered by you, dear taxpayer.
The great credit crisis of 2007-2008 is slouching towards its Bethlehem, a full faith and credit crisis for the United States of America. This die was cast at the first TAF auction, when the Fed chose to pull private credit risk onto taxpayers' already strained balance sheet, rather than endure any unpleasantness. Covered bonds may prove to be a success with investors. But, careful what you wish for. The more banks sell, the more we're all on the hook, if the loans go bad. Covered bonds issued by "too big to fail" banks are basically equivalent to mortgage backed securities guaranteed by Fannie and Freddie. It's just another way of putting private-sector bells and whistles on a public sector assumption of risk.
These bonds are seen as a way of "unfreezing the housing market". The housing market seems frozen because in many areas, relationships between home prices, rents, and incomes are still out of whack. Assuming relatively stable rents and incomes (bad assumption, I know), mortgages in "stuck" markets made at or near current asking prices are likely bad investments. That suggests the implicit taxpayer guarantee won't expire unused. The more covered bonds are sold, the more extreme measures or hidden subsidies will be required to prevent household names from failing.
The committee to save the world is you, and we will be grateful for your contribution, although we will never thank you, or admit that anything other than the skill of our red knuckled, fabulously wealthy financiers had anything to do with the eventual recovery. That period of commodity inflation and steep yield curves was just a market outcome, a fact of nature. Of course our proud financial institutions were always going to weather the storm. They are the best and most sophisticated in the world. Thank goodness for private enterprise.
[HT Yves Smith on the slouching towards Bethlehem thing. BTW, my use of the term "taxpayer" is imprecise, state guarantees are really backed by "taxpayers and/or those most vulnerable to inflation (low bargaining power workers and those on fixed incomes)". My guess is that we will use tradables inflation more than outright taxation to save the whales. FD, I'm short long-term Treasury futures and long precious metals, going with that whole full faith and credit crisis scenario. As always, this ain't investment advice, I frequently lose my shirt so go copy Warren Buffett or something.]
[I]f you have lent to people in a currency where interest rates suddenly go to 50 percent (as happens in some devaluation crises), your funding cost (deposits) will rapidly go to 50%. However if you pass that on to your borrowers they will fail. You will suffer credit risk and possibly go insolvent. If however you have offered fixed loans to your borrowers you will wind up with huge funding mismatches – and possibly go insolvent. For small moves there is a difference between credit risk and interest rate risk. For large moves there is no effective difference. The same analysis applies to currency and credit risks.
This goes some way towards adressing Tyler Cowen's demurral...
I cannot see that the credit of the United States government is in danger. There is a) the printing press, and b) our location on the left side of the Laffer Curve.
I agree with Tyler that the US government is more likely to print than default outrught, if those are the alternatives (though do recall this from the generally levelheaded Accrued Interest). But, for large moves, I think the distinction between credit risk, inflation risk, and currency risk is largely academic. (Regarding Tyler's second point, Robert Olson hits the nail on the head in a Marginal Revolution comment, "Being on the left-side of the Laffer Curve doesn't matter much if the political situation makes it impossible to raise taxes.")
- 29-July-2008, 11:09 a.m. EDT: Fixed misspelling of Warren Buffett's name. Thx Nemo.
- 31-July-2008, 3:03 a.m. EDT: Added the word "by" somewhere where it was needed. Added the update regarding credit risk vs inflation/currency risk.
|Steve Randy Waldman — Tuesday July 29, 2008 at 4:39am||permalink|