22 February 2009

Surreal~ Nolan

CNBC’s impassioned Rick Santelli suffered an impromptu “mad as hell and not gonna take it any more” moment. And there is definitely plenty of dry kindling lying around awaiting a spark. Mr. Santelli's outburst could very well mark a turning point for national policy debate. Hopefully it is not used as a battle cry for more rage and open “class warfare.” Public outrage, as understandable as it is, is a troubling facet of The New Post-Bubble Landscape.

There’s no way around the reality that government bailouts and stimulus packages are inequitable and unjust for most of us. There is hope that they bolster stability for the system overall. The majority of us are begrudgingly willing to pay a significant price to ensure stability. Policymakers will, of course, craft policy in hope of stabilizing an acutely unstable system. “Implosion” will never be an option for politicians and other policymakers. At the same time, the government’s (predictable) responses to a breakdown in market mechanisms provide such an easy target. As I tried to touch upon last week, policy debate that jolts deep ideological hot buttons is messy business.

The nuts and bolts of today’s reflationary policies will not be received warmly by the majority of taxpayers that work hard, live within their means, and pay their bills. Post-Bubble policymaking, by its nature, can be reliably counted upon to throw good “money” after bad. And the bigger the Bubble the greater the amount that will find its way down the rat hole.

In a highly inflated system, it matters little that, say, 90% of an economy’s loans are sound. The problematic (say) 10% remains more than sufficient to bring down a highly leveraged and fragile financial sector - which risks collapse for the entire Bubble Economy and Credit system. So, inevitably, policy focus will be on the minority “10%” group of problem borrowers, institutions and their loans. And it certainly doesn’t help the tone of policy discourse that this group is comprised of an indeterminable blend of millions of “misfortunates” and “miscreants”.

It is fair to suggest that the greater the public outrage the less compassion forthcoming for the unfortunates and the greater the hostility directed toward policies viewed as benefiting the undeserving. And the bottom line is that the Post-Bubble policymaking focus is, by its nature, unjust and inequitable. Moreover, it comes on the heels of a Bubble period recognized in hindsight as especially unjust and inequitable. It all creates a quite complex and volatile mix of finance, economics, policymaking and social tension. At the same time, an increasingly emboldened government – with its simple mandate to make things better – mobilizes massive financial and real resources in its less-than-studied effort to fulfill its newfound role as System Stabilizer of Last Resort.

I will not jump into the fray regarding the merits (and fairness) of modifying millions of troubled mortgages. Instead, I this evening want to address the Administration’s less arousing announcement that it is boosting the taxpayers’ commitment to Fannie Mae and Freddie Mac recapitalization from $200bn to $400bn. Consistent with the overarching goal of not bankrupting our nation, it is disconcerting that the GSEs have apparently once again evolved into primary tools of government reflationary measures.

It is worth noting that Fannie’s and Freddie’s combined books of business (mortgages held and guaranteed) jumped $31.3bn during December to a record $5.319 TN (strongest growth since July). For the year, their books of business jumped $326bn (6.5%), as their combined balance sheet assets rose 10.2% to $1.592 TN. In just two years Fannie and Freddie’s combined books of business ballooned by $964bn, or 22%. Embedded taxpayer losses are now expanding exponentially.

I am protesting the use (once again) of the GSEs as mechanisms for systemic reflation. These institutions were at the heart of the U.S. Credit Bubble, a Bubble that severely distorted the U.S. financial sector and economy - only to then set its sights on inflating the world. Today’s synchronized busts create a precarious global policymaking dilemma at home and abroad. My greatest fear at this point is a Government Finance Bubble that insidiously destroys our government’s Credit worthiness, similar to what occurred on Wall Street.

I understand the argument for temporary government deficit spending. I appreciate the recent imperative for Fed’s balance sheet expansion to accommodate financial sector delivering. These hopefully temporary fiscal and monetary policy measures can be quantified, monitored, debated and regulated. Conversely, the GSEs are financial blackholes. Their operations are today dictated by political goals, yet have seemingly no objective oversight (“we’re all inflationists now”). And being too big to really fail, the markets freely finance these failed institutions.

I scoffed at the notion of GSE privatization. They were simply much too big. To be sure, their financial deficits had become as overwhelming as their roles throughout the mortgage, housing and overall global financial markets. Their implicit government guarantees were poison for distorting various markets – and the scope of the ensuing Credit Bubble ensured that there was no way for Washington to ever retreat from their backing of these institutions.

It is imperative that the GSEs not be used as stealth mechanisms for system reflation. The critical issue is not the federal government directing Fannie and Freddie to modify mortgages. What I fear is another round of massive GSE balance sheet and guarantee expansion. It is today too politically tempting to use GSE obligations to reflate. Their debt and guarantees are conveniently not counted as part of the federal deficit, while the GSEs provide a convenient mechanism for transferring mortgage risk away from the troubled banking system and securitization marketplace. And as long as the markets provide ample cheap GSE financing, the revelation of the true loss to be absorbed by the American taxpayer can be left (to grow) for another day.

Besides, it is increasingly clear that policymaking must turn its focus directly to our troubled banking system. The basket approach of stimulus and myriad measures to bolster housing and securities markets is doing little to alleviate concerns for the solvency of some of our major banks. The hope was that new measures would significantly buoy market confidence and, thus, provide general support for the banking system. It’s just not working. The markets have grown too accustomed to downplaying every policy move in anticipation of the next more dramatic one. The markets are forcing policymakers to hit the banking problem head on.

The markets are now abuzz with “nationalization.” “The horse seems to have left the barn,” as they say. One way or another, a reasonably functioning banking system is an absolute priority. We are in for a fascinating few weeks, as the Treasury and Federal Reserve grapple with what dramatic measures would have the highest probability of effectively restoring confidence in the banking system. The environment is almost Surreal.

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