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Monday, 10 March 2008

Paul Krugman

Krugman gave a good explanation of the theory between Fed interventions like the TAF and its new $100 billion repo facility announced Friday (Krugman deemed the post "very wonkish" but it just has the sort of conceptual charts you see in econ courses, no scary formulas. Curious readers should most assuredly have a look).

His bottom line is sobering:


The financial crisis seems to have entered its third wave. Panic in August, then partial recovery thanks to lots of money thrown at the system by the Fed. Renewed panic late fall, then partial recovery thanks to even more money thrown in, especially the Temporary Auction Facility. And panic has set in yet again...

So the Fed is throwing another wave of money in, via the TAF and also additional loans to banks. All this lending is backed by collateral: the banks are setting aside various stuff, but probably mainly mortgage-backed securities....

OK, this is just like the way you analyze sterilized intervention in currencies. And the usual problem with such intervention applies: the financial markets are so huge that even big interventions tend to look like a drop in the bucket. If foreign exchange intervention works, it’s usually because of the “slap in the face” effect: the markets are getting hysterical, and intervention gives them a chance to come to their senses.

And the problem now becomes obvious. This is now the third time Ben & co. have tried slapping the market in the face — and panic keeps coming back. So maybe the markets aren’t hysterical — maybe they’re just facing reality. And in that case the markets don’t need a slap in the face, they need more fundamental treatment — and maybe triage.

There has been a small. lonely cohort, whose members include Australia's former Reserve Bank governor Ian Macfarlane, Henry Kaufman, Steven Roach, and James Hamilton, who early in the credit upheaval argued that monetary measures would not be sufficient, that our regulatory regime is outdated and needs a serious overhaul.

As a reader reminded me, the credit implosion has often and inaccurately been characterized as a subprime crisis; it should instead be depicted as a securitization crisis. In a wonderful illustration, "How the French invented subprime in 1719," James Macdonald in the Financial Times draws out the key parallels between the French Compagnie des Indes bubble of 1719-1720. The key element: repackaging bad debt (you might almost think of it as rebranding) and securitizing it made it vastly more attractive. Liquidity (or the belief that there would be liquidity) made investors willing to hold assets they would otherwise shun.

In our updated version, packagers used credit enhancement of various forms to sell dubious credits. But bear in mind: these same mechanisms were also used to sell higher quality debt as well, presumably for a better price.

There are two factors at work. The first is that, without any optical or real improvements to the credit quality, securitization is cheaper than bank intermediation. Any study of banks' share of total financial intermediation will show a steady drop since 1980. Banks' cost of capital and deposit insurance payments make them a more costly source of funds for all but small borrowers (and even those now find their assets securitized, via auto loan, credit card, and the well know mortgage bonds).

But separately, investment banks cleverly extended the market for securitized credit beyond what in retrospect was its natural boundaries: sourcing increasingly dodgy assets because the lucrative fees all along the pipeline created huge incentives to con investors; the use of credit enhancement that broke down under stress; the creation of considerable structural rigidity in the relentless pursuit of efficiency and profit (namely, the inability of mortgage servicers to do mods because their operations are incapable of doing anything on an individualized basis).

Securitizaton has become vital to the functioning of our credit system. But we are seeing multiple failures: not only has mortgage related debt become harder to sell, but the asset backed commercial paper market has been shrinking, and credit card debt is becoming much harder to sell as well. Some of this no doubt is due to worries about deteriorating borrower performance, but it appears to be exacerbated by the strains on the securitization machinery.

Paul Jackson of Housing Wire elaborated after attending the American Securitization Forum annual conference:

While the monoline business may or may not be less important in the municipal bond markets due to the unbelievably low incidence of defaults, the guaranty business is actually far more important to the MBS business than most have given attention to thus far — precisely because defaults can and do happen.

For secondary mortgage market participants, resolving this crisis isn’t just a piece of the puzzle; it might be the puzzle. At the American Securitization Conference in Las Vegas last week, many investment bankers suggested on panels and in hallways that the bond insurer mess is the single largest issue keeping the private-party market from having a chance at establishing any modicum of recovery going forward.

This is troubling, since a fair number of people (yours truly included) believe the bond guarantors' days are numbered. And the need for credit enhancement has been implicitly acknowledged in the calls for Fannie and Freddie to play a larger role. That, however, seems to be going pear-shaped due to the decay in agency spreads that appears to be in direct response to these very proposals.

Certain elements of the securitization problem have gotten a great deal of attention, such as the problematic role of the credit agencies, bad incentives, lack of transparency. But most of the approaches attempt to address isolated elements of the problem, independent of each other. That isn't going to work. There needs to be an integrated, systematic approach to reform.

The fallback, going back to finance circa 1980, with banks holding loans on their balance sheets, is such a costly reversal as to be unthinkable (particularly given the near-impossibility of coming up with sufficient bank equity to support big enough balance sheets to carry all those loans).

We need more serious attention to the real problem. I don't pretend to have answers, but if people like Krugman, who have the attention and respect of policymakers, can get the fundamental issues on the table, it improves the odds of working our way through this mess.

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