Thoughts on Fixing the Credit Crunch

We're in a pretty big pickle right now with the credit crunch.  Lenders won't make loans.  Any loans.   And credit default swaps (insurance against bond-defaults) have amplified the problem tremendously.  With each fall of a financial institution (Lehman Brothers most notably), their bond obligations were insured many times over in the CDS market, and this in turn will put other financial institutions in peril. 

The word "credit" comes from the Latin "credere", meaning "belief".  And, burned by mortgages gone bad, lenders don't believe anymore.  More than anything, lenders need to believe that someone can pay them back.  Sure, it helps to have the governments of the world step in and say that they will make guarantees.  But it doesn't really create long-term belief, once the $700 billion runs out.

Soured on so many very bad loans, lender/investors from abroad and at home are shutting off the faucet.  I think it's temporary -- because we'll gradually see some investors making outsize returns on loans after the fashion of loan-aversion dies off -- but the current crisis highlights that systemic changes are needed to avoid this kind of problem in the future. 

Obama claims (reiterated in tonight's debate) that the primary cause was the de-regulation of the late 90's.  I think he's partially right. 

But deregulation has brought many benefits when the system to be deregulated has transparency as a check/balance, so a market can truly function.  When de-regulation happens in an opaque market, unfairness, corruption and manipulation are quite possible.  Yet, when poorly-implemented, over-regulation of markets can introduce far too much unhelpful friction, or worse, it yields corruption, when favors are doled out the chosen few.

I think the most overlooked causes of today's credit crunch are that derivatives and mark-to-market accounting are far too opaque, illiquid and subject to manipulation.  I don't think over-regulation is the answer -- I think standardization and more open markets are.

To fix the credit crunch, I think the first necessary step is to understand the underlying causes.  Here's my thinking on the central causes:

• About five years ago, the Fed dropped interest rates to near-historic lows.  At one point, the Fed Funds rate was around 1%.  Remember, US Treasury Bonds were a favorite investment vehicle for investors looking for a decent return on a safe investment.  The Fed also signaled that the Fed Funds rate wouldn't be rising any time soon, for more than a year.
• Wealth managers, both foreign and domestic, calculating an extremely low ROI on Treasuries, all of a sudden found themselves without a great "low risk / decent return" investment.  US Treasuries returned historic lows.  Where did they look?  Individually at first, and then quickly, collectively as a group, they looked to U.S. residential mortgages.   The historic data suggested that mortgage-backed securities offered a relatively low risk investment and a decent return.
• Republicans in Congress championed deregulation and at the same time, Democrats in Congress advocated an aggressive expansion of low-income loans by Fannie Mae and Freddie Mac.  Both were a toxic combination in an opaque market. 
• Foreign investors had a ton of additional money -- newfound oil funds in Russia, trade surpluses in China.  There was a huge amount of money that needed a place to go.  Equities seemed risky, certainly far riskier than a traditionally relatively low-risk investment like mortgages.  
• As a result, a huge amount of money moved, en masse, into buying up bundled mortgages and/or collateralized debt obligations (CDO's). 
• Meanwhile, derivatives (contracts between parties designed to shift or allocate risk/return) took off, slicing up various risky assets into opaque, hard-to-value chunks.  In particular, credit default swaps (CDS's) rose and became a massive, speculative and unregulated market.  (The CDS market is about 2-3 times bigger than the entire stock market.  See this prescient article, Credit Default Swaps:  The Next Crisis? in from Time Magazine, March 2008.)
• Housing prices skyrocketed, particularly in the most speculative areas.  This created a "perceived wealth" effect among many American consumers. 
• As a result, vastly more supply of mortgage funds chased relatively few good deals -- and as the laws of supply and demand would dictate, the rules started relaxing on who could get a loan.  No income, no assset ("NINA") loans became the norm, even though they were pretty absurd in concept.
• Sure enough, speculators and homeowners on the other side of the table took advantage of this seeming "free money".  

Politicians have approved at least one gigantic ($700 billion) bailout.  (To put that in perspective, that's roughly as much as we've spent in the entire Iraq War to date). 

But nothing in these bailouts really address the systemic reasons we got ito this mess. 

What are some of those systemic reasons, and how do we fix them?

• We American consumers need better values.  It's not OK to have an obsession with wealth and materialism, and lie to get it.  Debt is a tool, and OK in moderation, but not in excess.  Debt, in general, is something to be feared, not to be lauded.  With all the finger-pointing toward Wall Street, we are forgetting that it takes two parties to make a loan.  Hundreds of thousands (millions?) of people put ink to paper, and wrongly pledged that their income was as stated, and that they could afford the loan they were signing up for.  They lied, and most knew it. 
• Another systemic problem is our ridiculous expectation that somehow, housing prices must inexorably march upward.  Let's take a deep breath -- lower housing valuations aren't entirely bad, and returning to valuation levels of (gasp!) 1997-2000 isn't so bad.  Let's remember there's a generation following us that actually needs to be able to buy a house some day.  Do we want to require them to be millionaires?  For those of us who already own a home, let's remember that many property taxes are pegged to home valuations.  It's not true that rising home prices are always good. McCain's recent idea to buy up bad mortgages to try to prop up home prices is just ridiculous, in my opinion, even more misguided than Obama's eagerness to hand out Federal checks (paid for by taxpayers) to people who don't even pay any taxes. 
• Wall Street needs to remember that they have a fiduciary duty, and represent investors.  We need a little more of the 1940's and 50's "Greatest Generation" ethics.  What happened?  Money was just too easy to make -- during the peak of the mortgage frenzy, all you needed was a pulse to be a mortgage broker, because banks were hungry to do a deal on behalf of their (largely foreign) investors, even though they knew that things like No-Asset-No-Income qualifiers were broken.  "Stupid money" was chasing any kind of mortgage, and it was a race to the bottom to relax common-sense rules that would protect the buyer/investors up the chain.
• The rise of complex financial derivatives is particularly pernicious; something Warren Buffett and others have warned against for years.  The biggest problem, to me, is not that derivatives exist, but that they are completely opaque to consumers, journalists, the market at large, investors and government, and need to be transparent.  Immediately.  Tomorrow.  Lest this sound like an esoteric point, do you wonder why it seemed that things were running so smoothly, and then all of a sudden -- boom! -- you had Paulson and Bush on TV saying we're facing a financial catastrophe?  Why was this so sudden and dramatic?  It's because derivatives are opaque -- impossible to get visibility into -- and they can also dramatically amplify bad decisions (think doubling-down in Vegas when you're deep in the hole).  We've seen this movie before at Long-Term Capital Management (read the excellent account in "When Genius Failed"), and Enron ("Smartest Guys in the Room", "Conspiracy of Fools", "21 Days".)
• Derivatives are highly illiquid -- usually between a handful of parties, over the phone and in-person.  To get a market flowing for these, I think we need standardization and a NASDAQ for all derivatives.  Futures got standardized and "marketized" [sic], why not derivatives?  Why aren't we hearing from politicians about the need to create a transparent, automated and standardized market for derivatives?  Why can't I go to Yahoo Finance or Google and find out how many derivative deals Morgan Stanley or US Bancorp have on their books, and with whom?  We need that level of visibility.  Imagine what CNBC, WSJ, 60-Minutes and others could do with that information.  In the long run (and also in the short-run), it helps shine a bright light of proper valuation.
• Mark-to-market accounting.  Remember this phrase.  This is one of the things that allowed Enron to get away with shady accounting (along with off-balance-sheet financing), needs to be suspended, or, at the very least, overseen by an independent body.  Mark-to-market accounting works just fine when the market is public, and transparent.  Every time you look at your stock portfolio of publicly traded securities and think "OK, I have $X in value", you are doing your own mark-to-market accounting.  So, it's a useful tool and it's not entirely bad.  The problem, especially with opaque derivatives, is that there is no real market.  It essentially allows the fox to guard the henhouse and state whatever value they think is appropriate to their portfolio.  (Another way to put this -- when we say mark-to-market accounting, which market, precisely are we talking about?  Which market stepped forward and actually stated a price for that CDO on your books, and what information did they use to price it?  The point here is that without a transparent, liquid market, there is no accurate price.  It's whatever they say it'll be.)  This "finger to the wind" valuation of CDO's on the books caused countless banks and investment houses to overstate their assets, which in turn reduced their "real" reserves they planned to have on hand.  This accelerated the over-leverage and under-represented the risk that firms like Bear Stearns and Lehman Brothers undertook.  

These are just a few quick thoughts on this mess.  It pains me that we're trying to solve this immediate crisis by raising yet more debt from abroad.

It's absurd that we are effectively borrowing from China/India/Russia once again so that we can kick this ball, like the even uglier Entitlements ball, down to our grandchildren's generation, without fixing the underlying problem.

Comments

[Rusty]

Why will China and Russia continue to buy the nearly $1T of debt we're likely to run up this year and probably another $1T next year?

They will at least put pressure on higher returns and interest rates which will put a crunch on liquidity and reduce the amount of borrowing available to non-federal institutions.

I'm not sure it will come to this, but you do have to wonder why China and Russia (ironically former communist and socialist economies) will thinking we're good for a few more $trillion dollars.

[Steve Murch]

I think the theory (hope?) is that China has become so dependent upon US consumer (and business) spending that if we fail, they fail. So, it would be in China's interest to keep lending us money. And it's hard to look around the world and find a better bet.

But, then again, who knows.

[K T Cat]

The politics of the situation are symptomatic of the disease. We’re a self-indulgent world. Keynesian economics is the economic partner to secularism. It excuses self-indulgence which we later have to pay for. (See also: prison population, post sexual revolution.)

Take a look at the great slideshow over at the A VC blog.

http://www.avc.com/a_vc/2008/10/watch-this-slid.html

When you can find a politician or a political party that looks into the camera in a debate and says, "the problems in this country look back at you in the mirror every day. You can't have things you don't pay for" you let me know. In the meantime, spare me the praise for Obama. He's the worst of the lot. Tax cuts for 95% of the population? Please.

The short term solution is to allow the smoke to clear in the valuation of the mortgage backed securities. The long-term solution is much harder. It’s time to put down the vibrators and throw away the Sharper Image catalogs and get back to thrift and self-denial.

It’s not about the politics at all.