Friday, February 20, 2009

Whitney's Reality Check

Continuing to break down some recent comments on CNBC....

Steve Auth is Chief Investment Officer at Federated Investments. From everything I can ascertain, he's a very smart and successful asset allocator. I have chosen to "pick on him" a little bit because he appeared on CNBC and made some very mainstream and conventional comments. For 99% of financial history, everything Auth said would have been true, so he reflects the traditional thinking I wish to critique. We're at a major inflection point now and these ideas need to be questioned.

Steve Auth on CNBC 2/20/09

Auth says "we are not in a great depression scenario" and argues that our current monetary system will save us from the deflationary cycle caused the gold standard in the early 1930s. I attack this assumption in this blog entry and in this one.

During the Great Depression "there were no dollars in circulation in some places in the country and things were very, very tight ... the policy response here has been completely different ... The fiscal stimululus plan hasn't been completely stimulative, and in a lot of people's minds, it isn't a plan, but we're getting there, and at least we're addressing the issues."

Let's compare this perspective with the views of Meredith Whitney, who has emerged as one of the shining stars of this financial crisis. (I hope she doesn't mind me setting her up in this ficticious debate with Steve Auth.) She spoke Thursday night to CNBC's afternoon anchor Maria Bartiromo:

"You've got years and years worth loans underwritten with faulty assumptions. Those are car loans, credit-card loans, auto loans, and obviously mortgage loans. And those have to work through the system. There has to be a group of consumers that lose credit and a lot of consumers will lose access to some of their credit."

I consider Whitney's comments as a rebuttal to Auth's point about how things are different than the early years of the Great Depression. In the early 1930s, banks in some parts of the country couldn't lend because they lacked physical gold. Today, some banks cannot lend because they are insolvent. Just as certain geographical areas were affected in the 1930s, today the problems revolve around certain kinds of loans... Whitney lists these as auto loans, credit cards and mortgages.

Auth also says "... the policy response here has been completely different ... " than during the Great Depression.

I am not sure how Whitney would respond to this, but I think it's wrong in spirit. Auth is correct on the surface: During the early 1930s, policymakers "tightened" credit and exacerbated the problem, while today we have "loosened" credit and "stimulated" the economy.


My point is that, just like in the early 1930s, policymakers have responded by embracing convention, despite evidence that new kinds of thinking are needed. For instance, our traditional policy tools are designed for a financial system dominated by banks rather than capital markets. That's why the Fed's earliest actions were interest-rates cuts and liquidity facilities. They viewed the problem as existing on bank balance sheets, when in reality it was to be found in the capital markets. Thanks to securitization, globalization and deregulation, banks had become adjuncts of the bond market. Everyone knows that banks stopped holding loans on their balance sheets, but no one asked "what does this mean for the way we approach problems?"

I have been arguing this point since the crisis took root in October. For instance, home mortgages represented 65% of bank deposits in the U.S. in 1974. People were borrowing money that someone else had saved. By 2007, home mortgage debt had ballooned to 160% of bank deposits. Now people were borrowing money that came from somewhere else ... the bond market. During the intervening years, Fannie Mae, Freddie Mac and private-label mortgage issuers -- all of which rely on the bond market -- developed a lending system independent of banks. Yet in the years 2007 and 2008, the Fed was still using policytools developed in the 1970s and earlier.

Yes, the Fed has managed to affect some improvements in the capital markets. Corporate debt issuance surged to a record level in January. But I believe if you look at the underlying causes, they still support my thesis.

First, when the Fed cut interest rates to 0.25%, it caused Treasury yields to fall so dramatically that corporate yields had to follow them lower. The same thing applies to the various and conflicting rumors about how the government wants to buy mortgage-backed securities and drive rates below 5%. These trends caused an improvement in the capital market by pushing rates lower.

Secondly, the FDIC is now insuring bank bonds under the Temporary Liquidity Guarantee Program (TLGP). Many experts celebrate the fact that these government-backed deals represented less than 10% of all issuance in January. Yes, this is positive, but I maintain that few of them would have priced without the TLGP. Why? Because without the government's support, Bank of America and Citigroup would have both collapsed by now and the credit market would be in utter disarray. The TLGP allowed the bond market to remain functional. Again, the policy succeeded because it fixed a problem in the capital market.

Importantly, Whitney and I seem to be on the same page regarding the importance of capital markets. She's been predicting a broad contraction in lending since last year because of the collapse of securitization. I quoted her and Jim Bianco on these points in this blog entry.

In the 1930s, the conventional thinking was based on the 19th-century gold standard. Faced with a credit crunch, the rules said to raise interest rates because that would attract gold, against which the banks could lend. Unfortunately, this doctrine had failed to adapt itself to the changes of WWI, when the gold standard essentially died.

Today, the conventional thinking is based on the 1970s model, ruled by bank balance sheets. Faced with a credit crunch, the rules say to cut interest rates because that would make it easier to lend. Unfortunately, this doctrine has failed to adapt itself to the changes resulting from globalization, securitization, deregulation and the rise of capital markets. For instance, I personally suspect that the Fed's rate cuts in September 2007 unleashed the credit crunch as we know it because it caused many "leveraged investors" such as SIVs and hedge funds to sell riskier assets. I know this is a very unorthodox view, but some evidence does exist to support it. See this posting for more.

In other words: In the early 1930s and today, the Fed did the conventional, accepted thing to deal with a credit crunch. In both cases, this had the opposite effect of what was expected because the ground had shifted beneath their feet and the intellectual tools had not yet caught up with the new reality.

Again, I am not sure how much Meredith Whitney would agree with how far I take some of these points. Let me make very clear that my comparisons between now and the Great Depression are my idea alone.

Returning to my ficticious debate, Steve Auth says:

"The fiscal stimululus plan hasn't been completely stimulative and in a lot of people's minds it isn't a plan, but we're getting there, and at least we're addressing the issues."

Whitney responds..."So many people were so hopeful about this administration really making a difference, and put so much faith into the administration. What I thought was a mistake of this proposal was it underestimated the intelligence of of the American people because it was built up obviously to be this great saving grace. Somebody set those expectations and then there was nothing behind it."

I think in many ways the Obama administration's response to this financial crisis has been similar to Lyndon Johnson's persecution of the Vietnam War. He always viewed it through the lens of Congressional politics, rather than war. In his world, you could always make a deal go through by adding a little pork for one legislator here or giving a nod to another legislator there. Compromise is the mothers milk of making a bill into law. That approach didn't work as well in a real war and caused him to make some fatal compromises, such as refusing to invade the North. A politics-based worldview kept Johnson from understanding the problem correctly, costing millions on both sides their lives. Tim Geithner seems to resemble Johnson's Defence Secretary Robert McNamara, who apparently said that loyalty to Johnson was his main guiding principle. Just like McNamara's Vietnam policy, Geithner's rescue plan and Obama's stimulus package seem to be much more based on the dynamics of American politics than on the actual problems on the ground.

As Whitney says:

"We will get to the bottom when we address all the issues. But some of the obvious issues have still not been addressed, and that's what makes me still nervous."

Sometimes, I think this blog should be renamed the official Meredith Whitney Fan Club because I cite her so frequently and with such admiration. However, I don't agree with her on everything. She supports the rise of new smaller lenders to replace the Citigroups and Bank of Americas of the world. While I agree with this in principle, I think it will take years to work. Instead, I think the government should hire Whitney, Janet Tavakoli and Sean Egan to write new rules on how securitization "should work."

The New Junta?

They are fine analysts who have proven their competence. (It would be a welcome improvement over the rating agencies, which are conflicted by their reliance on debt issuance to generate revenue. See this post for more on that.) Once they have completed their work, the government would simply buy asset-backed securities and mortgage-backed securities that follow the new rules.

While it might sound revolutionary, this is how Fannie Mae transformed the home-mortgage industry and mandated many of the standards we now consider "normal," such as 20% down and 30-year terms. Once the government has established new standards for securization, private capital will return to the asset class and debt origination will resume. Most Americans already do business with companies like Bank of America and Citigroup, thanks to decades of franchise building by those lenders. I don't think Whitney is giving enough weight to the immense complication and diffulty involved with tens of millions of people changing banks at the same time that many have lost their jobs and face huge losses in the stock market. In a crisis like this, you want to focus on as few issues at any given moment in time. After all, that's precisely why the government has propped up the biggest banks -- because so many people depend on them for so much.

My capital markets-based plan would use the infrastructure of the moribund megabanks to keep credit flowing in the economy. I know it's a bit of a gruesome analogy, but imagine a pregnant woman has an accident that renders her brain dead. The husband chooses to keep her on life support until the child can be born. That's essentially what we need to do with Citi and B of A.

Another concern with Whitney's plan is that she wants the government to "supercharge" small banks with capital so they can expand into big national banks. She says this money should be "nonpunitive," which leaves many unanswered questions. Would Harry Reid and Nancy Pelosi allow executives to earn more than $500,000 a year? Would they be allowed to have corporate jets? What is the future for any financial that relies on public money? So far, government capital injections have proven the kiss of death for banks. Given the political climate now, this could be more of a hindrance than a help.

Under my capital markets-based plan, the government could hold asset-backed debt securities without disrupting the market and sell them when conditions improve. Furthermore, the government would profit from the measure because the bonds would always be priced at a level above the Treasury's cost of funds. This is called "positive carry." (One idea that should be considered is the abolition of LIBOR in favor of T-bills as a benchmark for short-term floating rate debt. I am not sure it's a good idea, but I think it should be discussed.)

My idea also recognizes that in today's world, capital markets run the show. All assets will try to price themselves against the largest and most liquid market, so that is where attention should be focused. Fixed-income money all is more or less or the same thing under most circumstances -- except during a crisis like now. If Treasury yields fall, junk bond yields will follow. Investors know they have to tolerate less liquidity and corporate defaults, so they simply demand extra yield to compensate.

Whitney makes a few more important observations about how the weakening consumer and falling home prices are keeping banks on the ropes:

"Consumer loans ... were underwritten with false assumptions [ and ] diminish on a daily basis as the consumer gets increasingly strapped ... Peak to trough house price expectations... started the summer 2007 [ forecasting ] a 10% [ decline ], now gone up to 30% Now it looks like it will be closer to 40%, so they have to keep paying cash up, keep boosting reserves. And, their own earnings power is diminished, which means they are not earning capital and they can't make more loans. So, they have to keep shrinking their assets."

Since early October, I have argued that this financial crisis will continue as long as home prices continue to drop. Unfortunately we have entered a vicious cycle where the financial crisis is also causing home prices to drop because people can't get mortgages and are losing their jobs. Policymakers must focus attention on the houses because they are the collateral behind mortgages. As long as they continue to lose value, the banks that lent against them will keep getting squeezed. Today is different from previous blowups, such as the S&L debacle. The consumer economy was still going strong as consumer credit and home prices both rose steadily throughout the entire crisis. Despite a temporary glut in commercial real estate, most of the properties were sold off at a profit.

Today, the problem is much more severe because consumer credit and home prices are both plunging. This situation is truly reminiscent of the Great Depression, which was the last time the economy truly had too much stuff, and not enough demand for all the stuff.

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