I am posting a response I made to a newsletter reader who had some great questions...
Morning
Unfortunately I start with a major predisposition here regardless of some of the Kudlowish “greatest story never told” commentary out there. The government has no business or authority to make loans, purchase assets or engage in private business… period. It is not constitutionally authorized and it certainly is not within the Feds charter and for good reason. The very cynical concerns of some over the role and dangers of a “central bank” are put to rest here. Since we have leapfrogged legal authority with “New Deal” voraciousness it’s already done but that is the context.
Adding to the context is the accounting rules. Agreed that mark-to-market is a big part of the problem here. But there is a very real reason there is no “market” so we’re looking at changing the rules to meet the need. The market isn’t crazy, there are a majority of good assets out there and there is a significant pool of bad assets out there. The question is how good is the good and how bad is the bad? The market says it doesn’t know. In fact if you take the ladder up in write-downs for the past 18 months by those that were supposed to know when the marks were known, the underestimation of the problem can’t be ignored. To artificially write these assets up to held to maturity values assumes that someone has the risk based capital set aside to apply to them and system wide we don’t. Yes the market has thrown the baby out with the bath water but we need the baby back, not the dirty water.
This is the fundamental problem. Some $19 trillion in mortgage loans were made between 2001-2007. Most of it moved off balance sheet. Regardless of the tail you pin on the “how much is bad” donkey, the risk reserves that should have been on the systems balance sheet don’t exist. A very significant portion of what should have been set aside was paid in transaction fees to the parties along the way. The over collateralizations and insurance wraps have proven entirely inadequate in the face of too many bad loans. Yes I know it perpetuates itself, ratings downgrades, increased borrowing, lowered equity values leading to this death spiral.
The AIG “loan” was done for a reason. The company was about to fail. It got into its problems as did the others. It has good assets and bad assets. The private markets said too risky. For the government to act as if we’re going to make a profit is the same double speak engaged in when the fed waved it’s magic wand and opened up the auction facilities and began accepting poor quality assets as collateral.
I don’t prescribe to the household net worth numbers as an indicator of broad based economic conditions. The devils in the details; inflation, stagnant income, value of stock portfolios, inflated housing values (ala the current situation) vs. debt, the percentage of the population enjoying the increase etc. It just decreased some $533 billion.
The only reason we’re not close, yet, on the bank failures is because of massive, unprecedented, government intervention in the system. These interventions are not only going to cost the American taxpayer a fortune now and in the future, but we’re perpetuating the problem today. FHA has become the “insurer” of last resort and the crap they’re putting on the books and securitizing through Ginnie Mae as we speak, will be just another wave. By the way the early 2008 mortgage vintages are apparently showing worse than the 2006, 2007.
I’m not a doom and gloom person, these are just facts as I see them. This massive restructuring of the balance sheet is going to be a significant drain on the economy. If we do it successfully and appropriate risk reserves are required moving forward, that in itself is going to slow credit availability from these boom levels and everything, wages, growth, home values etc. will be going with it. Already too long and probably terribly boring so don’t want to get into the print money, inflation, Treasury interest rate conversation.
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