Wednesday, August 25, 2010

Stopping Deflation with Government Stimulus

Credit NY Fed
This post was inspired by a comment over at The Big Picture. Barry Ritholtz posted some interesting chart pr0n from the NY Fed's report on Household Debt & Credit and a commentator by the name of "HelicopterBen" brought up Richard Koo, whom I've written about before, and whose book I reviewed.

I feel like a broken record, but I'll say it again: Koo's GIGANTIC assumption is that the government will spend the money in projects with a NPV greater than zero. I quote myself below:
I'm just not comfortable leaving that decision up to the guys that decided to try to reflate the bubble by pulling-forward demand, subsidizing toy arrows and foreign liquor and build useless airports. Just sayin.
As I said in my response in TBP (I comment there as "X on the MTA"), trying to return to the good times by maintaining the money supply inflated is like trying to--ignore the negative connotation of disease for a second--infect a patient by inducing the symptoms. Or, if you prefer, curing the symptoms instead of the disease, either analogy works for me. I'm not going to rant about malinvestment, because I've already done so--although Pettis said it better  and then what Steve Waldman said it best. instead, I'm going to make a quick point about the money supply.

One of the Fed's goals is to maintain relative price stability. When Paul Volcker was first appointed Chairman of the FRB, he changed how things work and decided to try to control inflation by targeting the size of the money supply. Little '84 hiccups aside, it is in my opinion he did a good job navigating this new, uncharted territory. At the time this "monetarist" thing was fairly new, but it makes sense to control inflation by controlling the growth of the money supply. This works well because the Fed can act in the markets via the FOMC, and they can release accommodate expansion when it's needed and tighten when things are heating up too fast.

Koo--correctly, in my opinion--argues that during a large-scale deleveraging, when rates are already pushing zero, monetary policy becomes impotent. He argues that no matter how much money a central bank puts out, it won't create inflation if businesses and households are all focused on paying down debt. I think he is totally correct. Where I disagree with him is where he argues that the government should become the borrower of last resort to keep the money supply from shrinking. Yeah, the government can soak-up funds when there's an excess, but can we trust them to release them when the private sector needs them? More so, can the government allocate capital in anything but a wasteful manner? Which brings me to my main point: why do we need to keep the money supply inflated, and businesses and households leveraged? I am not saying we should allow a violent deflationary crisis to take place, or the government shouldn't stimulate when it makes sense, I'm just saying there is nothing wrong with having excess reserves when there's nothing to invest them in. Americans are simply not going to halt spending because of small price declines are expected. I'll put money on that.

Borrowing is contracting and there is excess reserves because people want to save and pay-down debts. Some may need to save the money for future expenses, others may want to pay down the underwater component of a mortgage so they can refinance at a lower rate or sell and move. CC debtors may need to lower their debt-service so they can start spend that money elsewhere. Some may want to lower DTI ratios so they can borrow in the future. Slack in the system is a good thing, just like cash in an investment account. There is nothing wrong with not being fully leveraged or fully invested. Businesses and households are preparing and keeping their powder dry so that once a suitable investment comes, they can act on it. That is healthy and rational.

Businesses and households may be paying down debt because they have ugly balance-sheets as a result of the decline in asset values. Fixing balance sheets is not a bad thing, it leads to strong businesses that can grow once their internal problems are fixed. Trying to keep businesses and households in their current, insolvent and over-leveraged state to prevent a few bankruptcies is like locking up junkies and keeping them high so that they don't have to go through withdrawals: ultimately counterproductive.

I would favor going through a painful deflationary cycle and dealing with the bankruptcies of weak businesses and households, but if the Koo sympathizers really want to transfer debt from businesses and households to the government aka "the borrower of last resort", maybe we could do it by having the government borrow large amounts at record-low rates and sending checks to tax-payers instead of poorly investing it. Tax payers could then use that money to pay-down debts, get out of homes they can't afford, or consume and invest if they are so inclined. If nothing else, it would speed-up the process of getting consumers back to a healthy place where they can start spending again so businesses have an incentive to start investing again. Of course we'd have to deal with higher taxes to serve that debt, but something tells me Uncle Sam has a better rate than Joe the Plumber's Capital One card.

Monday, August 23, 2010

Gambling: The Wrong Way to Close Fiscal Gaps

image by jasonswell
I have nothing against gambling; I love, love, love a good horse race and I've stayed up my share of nights at a craps table. I've played dice 'till sunrise, I buy Mega Millions tickets if the pot gets big and I've been known to wager a dinner tab with co-workers. However, gambling is not the way to cure fiscal woes. If states want to legalize gambling because the residents of the state in question want the liberty to choose whether they want to gamble or not, I am strongly for it, but not as a way to close fiscal gaps.
Gambling is a consumption activity. The only value that is being generated after everything nets out is whatever enjoyment gamblers got out of spending their money. There is no other net value being produced. Going back to Econ 101 (hi Greg!) we can't just all do each others' laundry. I have nothing against consumption, it is the reward we get for hard work, but you can't base an economy solely around it. As states turn to gambling to close budget gaps, it is increasingly important to remember how this all works:

Wednesday, August 18, 2010

Shut-up, WSJ: "Bond Bubble" edition

There has been a lot of noise in the blogosphere about the "bond bubble" (1) (2) lately. For what it's worth, I don't think there is so much a bond bubble as there is a system awash in liquidity that has to go somewhere. Some money is chasing momentum, some is chasing income, some is chasing yield that has more stability than equities can provide. I do think rates are absurdly low, but that's what happens in deflationary environments. The JGB bubble has been a "no-brainer" short for 15 years, but that trade has been a consistent loser for just as long. In general, I think bonds have limited potential to enter "bubble" territory right now because their value has a natural cap (that they trend to as maturity approaches) and because bubbles--in my mind at least--require massive amounts of credit to finance the purchases of the asset in a bubble, and that demand for loans would, you know, be reflected in higher interest rates that would halt the appreciation of bonds.

Tuesday, August 10, 2010

How Hogs Get Slaughtered: Structured Notes

In case you don't know, I work for an Independent Broker-Dealer. Near me is one of our bond guys, he specializes mostly in brokering bonds and other fixed-income instruments and some flow trading. Throughout the workday we'll chat about this or that and every once in a while he sends me some issue to look at if he finds them interesting or attractive.

A couple of weeks ago, he told me about a new-issue, a 20-year Bank of America CD. It was a tax, free, FDIC insured, floating-rate structured note with a 9% coupon and call protection for a year. I jumped out of my desk and came to his Bloomberg to check the deal out. We are a pretty small firm, around $5B in assets, so I don't know why we were getting an allocation. After all, most of our brokers would be buying no more than a couple of hundred thousand, maybe $1MM at most, to split between their customers. Something had to be wrong, otherwise someone higher-up would have picked it up first. With 20Y Treasuries yielding less than 4%, I was genuinely puzzled. Then, I noticed the terms of the deal:

  • Callable after 1 year
  • Floating yield (30YCMS - 2YCMS - 0.875%) * 4
  • Cap: 9%, Floor 0%
Yiiiikes! Let's go over each one of these features and see what they mean

Saturday, August 7, 2010

More on refinancing negative-equity loans

 Josh Rosner over at The Big Picture has a response to a plan similar to the one I proposed last week. I argued that breaking-off the underwater part of a mortgage and turning it into a full-recourse uncollateralized loan was likely to have little effect, since the collateral wasn't going to magically be worth more just because the banks needed it to. I wrote:
The government could create a facility that lends money to underwater homeowners that need to free themselves from a home.

This is not a giveaway, it is a loan. This is not a below-market-rate loan, and therefore carries no implicit subsidy. The loans should be made at a rate similar to or slightly higher than the original mortgage rate. Home-owners who are underwater and are being held-back from taking a job in a different area should be offered the loans, which would be contingent on a job offer. The loans would be used to pay-off negative equity at the time of a home sale. The borrower could then free him or herself from the home anchoring him or her down and return to employment
If the lender vowed to reduce the rate on the loans by a set amount if the borrower transformed the loan into a second lien on any new property bought, it could furthermore enhance the quality of these loans. These loans could then either be kept until maturity or sold to banks for securitization
The original idea behind this was that, especially for a distressed, undercollateralized loan, if you increase the quality of the borrower, you increase the value of the loan. I argued that because the Fed owns $2Tin MBS and Fannie and Freddie guarantee so much of the rest, it would actually be in the financial interest of the taxpayer to do this.

Josh, however, is responding to a slightly different plan. a mass, streamlined refinancing of underwater-mortgages. I tend to agree with some of the logic behind the idea, but, operationally, it would be a total nightmare.  I still think the best way to deal with it would be for banks to allow homeowners with no second lien to convert the underwater portion of their mortgages into a separate, uncollateralized recourse loan and refinance the house at an appropriate LTV. This help people sell their homes and downsize or move, without being forced to default on their debt.  Josh didn't respond to my plan. Josh doesn't know that I exist. In fact, judging by the traffic stats, only about 1.7 people have ever read this blog, but I like to chime in on everything.  Here is Josh's objections (along with my response):
- As a result of another prepayment-shock and the inability to model future prepayment shocks, investors would become even more unwilling to invest in MBS gong forward, or would begin to demand higher yields going forward; unwilling to invest in MBS going forward, or would begin to demand higher yields going forward;
 Oh, no! The government would stop subsidizing people earning abnormally high yields with unusually low prepayment rates! Shut up, Josh. Anyone who bought MBS in size knows that there is an embedded call option in the loans and how negative convexity works against you when interest rates drop. I agree that the streamlined refi process would be a mess, but that doesn't matter for a plan like mine.
- The interest rate risk that this would cause, as banks and the GSEs themselves all had to re-hedge their books at the same time, could precipitate a systemic risk issue;
Yes. They are all going to have to do that at the same time. By this same logic, why didn't the unusually low prepayment rates wreak havoc on their prepayment models and therefore their hedges?
- The prepayments would cost investors more than half a trillion in lost interest income;
I was under the impression that the government was trying to get out of the business of subsidizing bond holders at the expense of everyone else. I'm sure investors will find new ways to reach for yield or invest that money in, oh, I don't know, a value-creating process?
- Such a “streamlined” refi program would cost state and municipalities billions of dollars in transfer fees that they would normally be able to charge on a refinancing;
Well, if it wasn't for the program, the states and municipalities wouldn't get any fees, because underwater homes can't be refinances anyway. So they aren't really losing anything at all. They are just a road-block that's being worked around. Since the states just got $26B from Uncle Sam last week, they should just keep their mouths shut. Not to mention the benefits they'll reap from would-be defaulters and foreclosures staying current.
- Keeping borrowers in their homes with rate reductions could be argued to be consistent with maximizing value under conservatorship. A streamlined and across the board refi program that treats all borrower LTVs and other features the same would appear to violate the conservatorship;
I agree with the first part. The second part I'll leave to the lawyers. I do think that a mass-rate-decrease might be the cheapest way to minimize costs for the guarantors, though.
- The GSEs, according to their trust agreements, are prohibited from soliciting prepayments. If they were in receivership these agreements could be abrogated but they would still have to pay value on the contracts; and
- Servicer’s could solicit borrowers to prepay on the program but it would be a nightmare to operationalize and oversee such a massive program.