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.

7 Responses to “Which kind of credit crisis?”

  1. Burn it down. The financial sector should be allowed to crash. Financial stocks make up about 20% of the S&P value, compared to 6% in 1980. Salaries in the finance sector are out of sight compared to the real economy. We have no liquidity crisis, but an overvalued real estate and bond market. I have posted on Uncle Sam’s various attempts to prop up current finance sector entities and oppose all these efforts. My bottom line: either destroy the banks or destroy the dollar. It’s that simple.

    You talk about agency costs. As long as the finance sector can privatize profits and socialize losses, they will go on. I even have a tag on my blog titled “principal and agent”. It’s that bad in the financial sector.

    You talk about government becoming untrustworthy. I have a tag called “government deception”. The Mogambu Guru writes about government deception all the time.

    The US economy isn’t in that bad shape. Uncle Sam, with $9 trillion in debt and $54 trillion in social security and Medicare debt is bankrupt. We are due for a reckoning. When the Chinese and Japanese pull the plug, the dollar will go down the drain.

  2. I read Brad DeLong’s post and was not favorably impressed by it at all. I read better stuff by Yves Smith, Michael Panzer, Peter Schiff, The Mogambu Guru and others every day.

  3. John writes:

    I don’t think the day of reckoning will arrive in the nominal sense. I think it will crash in the real sense. See Recipe for hyperinflation.

  4. Carl writes:

    This is a reckoning because the financial sector has continued to operate as a secret system that deliberately obfuscates the true value of the derivatives it created. The whole process of securitization lends itself to concealment of risk. This is the fundamental flaw in the machine. Would a system that was open and allowed reasonable due diligence by investors even use offshore SIV’s as a critical part of its process? A system that needs to use foreign laws to evade taxes and other costs imposed by its domestic host is not viable long term. Since the passage of the Commodity Futures Modernization Act of 2000, which contains the “Enron Loophole”, ratified and codified the secret (outside of established exchanges) trading of credit default swaps (and energy futures) the system has spun wildly out of control with many trades not even recorded properly and likely never completed. A bailout isn’t even possible given the fact that many counterparies can’t even be accounted for when these derivatives fail, this is a reckoning approaching.

  5. Well, it is gratifying to have such an optimistic group of commenters. I do wish I could disagree with any of you, but I don’t really. So, I’ll just shut up.

    Or not. John, I couldn’t see anything on the other side of that link. It came up blank for me.

    Carl — “The whole process of securitization lends itself to concealment of risk.” That’s true, given how securitization has been done this decade. It’s not necessarily true, though. The late crop of securitizers sold their smack based on the allure of diversification, as if that were a magic elixir that eliminated risk. The one thing they didn’t do is set up what could be the most useful aspect of securitization — liquid markets that facilitate continuous price discovery. The recent bad securitization, bundled, complexified, and obscured the real assets beneath the paper, diminishing the informational content of “market prices”, such as they were. It didn’t have to be that way.

    IA — I’d never encountered Mr. Mogambo. I like financial writers who claim always to be wasted or hung-over. In these interesting times, inebriation is a mark of good judgement. Re your blog, I’m a regular reader now. I enjoy it much, though I rarely take note of the tags.

  6. John writes:

    Steve: Try this link again http://cij.inspiriting.com/?p=337

    The site was down for a while. But it’s now up again.

  7. Thanks for becoming a regular reader. You can find the Mogambu Guru at http://www.atimes.com. While he goes over the top from time-to-time, he’s almost always worth reading. Or at the least, I agree with 95% of what he says.