Monday, October 6, 2008

A credit-market solution that WILL work

This posting includes some of the ideas discussed below on my blog, but I have organized it into a single memo that I am distributing to policymakers:

Dr. Sir/Madam,

I am a financial journalist who covered the credit market deal-by-deal as the bubble was inflating the last few years. I have an idea for a solution to the current problem that would help much more quickly and cheaply that anything else discussed so far.

What: The Treasury Department should buy corporate bonds, commercial paper and municipal debt. Why: Mortgage securities have been turning toxic for more than a year, but have only posed a truly systemic risk in the last 2-3 weeks. Now the entire credit market is in danger of shutting down. Mortgage securities cannot be saved quickly because many were issued with two basic assumptions that are no longer in place:
1-Home prices don't decline.
2-Borrowers can always refinance to lower rates.
Now that these assumptions are out the window, mortgage securities will remain under extreme stress. The Paulson plan will be a wasted effort.

It's time to do triage. Two patients have moderate injuries and can be saved with care. A third patient has a 20% chance of survival, and will require so much time and attention that the other two will die from their injuries while we treat him. It's not a hard choice who should get the care in this scenario. The first two patients are non-financial corporations and state & local governments, while the third is the mortgage sector.

The credit market is grinding to a halt: Despite all the noise about the bailout package in Congress, the biggest news on Friday came out of Sacramento, which said it may need a $7 billion loan to keep funding basic services.
Observers across all spread-based asset classes -- corporates, high-yield, commercial mortgages and municipals -- see the same problems: A frozen primary market and a daunting accumulation of maturing debt. Total debt-capital market issuance in the Americas fell 47% in September from a year earlier, according to Dealogic, and the commercial-paper market posted its largest contraction ever last week.
This logjam needs to be fixed quickly, or otherwise healthy companies will turn sick. Last week, the head of a moderately sized steel company told me he had his first layoffs since the period after 9/11 because his customers couldn't get financing. He expects things to get much worse.
Corporations and state & local government account for tens of millions of jobs and trillions of dollars of economic activity. For the most part, they "did nothing wrong" in the housing bubble and still have relatively solid credit fundamentals (especially corporations). It's the external factors that are hurting them now.

How my plan will work: The Treasury needs to set levels for bond spreads. It should declare that it will buy AAA 5yr paper, for instance, at +100bp, AA at +120pm, etc... all the way down the ratings spectrum.
This will put a floor under prices and stop the vicious cycle in the new-issue market: Companies need to sell bonds, but investors demand huge concessions, making it impossible for companies to issue. The buyers aren't demanding concessions to be cruel, but because they know a lot of new supply is coming that will push their own holdings wider. This is the mirror image of a bull market, when people think they need to buy now or miss out on the upside. Only in this situation, people are afraid to buy because they expect prices to get even cheaper. A government “put” would remove that fear and allow the market to return to life.

Why it will work: The frozen term-debt market has pushed more financing into the bank loan and commercial paper sectors, which by definition are much less risk averse, even in a good market. If companies and municipalities could sell debt with tenors of 3+ years, it would take pressure off the short-term markets, reduce loan demand and insulate borrowers from turmoil at the banks. It's a painful irony that companies must now rely more on banks at the same time those institutions face their own worsening capital constraints.
Once the government establishes "official" prices for these securities, we'll see a dramatic improvement in the credit market and halt the spreading paralysis. It will do nothing to help the mortgage market, but it will draw a line around those assets and prevent the infection from spreading to the rest of the body. It's like amputating a gangrenous limb, to use another medical analogy. Furthermore, it would likely cost less and offer a bigger chance of "taxpayer upside" than the current program.

One final point: In the 1930s, US farms were producing too much grain, so the government took deliberate steps to support those prices. After all, those prices were key to rural incomes and farmers' ability to pay their debts.
Instead of a glut of corn, today we have a glut of credit securities. If their prices continue to plunge, they will drag down most of the economy with them. That's why my proposal is the only idea that could succeed quickly enough to stave off calamity.

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