7 March 2009

A Washington-Induced Bubble

A Washington-Induced Bubble:

March 5 – Bloomberg (Dawn Kopecki): “The ‘phenomenon of securitization’ must be curtailed by lawmakers to prohibit banks and mortgage lenders from shifting all the risk on loans they originate and sell to investors, U.S. House Financial Services Committee Chairman Barney Frank said. ‘I will be pushing for legislation that will make it illegal for anybody to securitize 100% of anything,’ Frank… told reporters… Securitization is a ‘large part’ of the problem in the housing market, he said.”

March 5 – Bloomberg (Scott Lanman and Craig Torres): “Federal Reserve Vice Chairman Donald Kohn came under fire from Democratic and Republican senators for rescuing American International Group Inc. without providing cost estimates or enough openness, risking public confidence in government. Federal aid to AIG ‘appears to be a bottomless pit,’ said Mark Warner… Regulators ‘are asking for an open-ended check and’ are ‘not going to get’ it, said Senator Robert Menendez… ‘The people want to know what you have done with this money,’ said Senator Richard Shelby… The $163 billion AIG rescue… may worsen prospects for congressional approval of more spending on bank rescues beyond the $700 billion Troubled Asset Relief Program, lawmakers said…”

Our Washington policymakers have too belatedly recognized the perils associated with unregulated Credit and speculative finance. They now come down hard on our Federal Reserve and Treasury Department officials, quickly losing sight of the Mountains of Blame to be spread around. Let us not forget that Congress repealed the Depression era Glass-Steagall Act back in 1999. And it is fair to remind leaders from both parties and both Houses that they are directly culpable for the spectacular rise and unfolding fall of the Government-Sponsored Enterprises (GSEs). I get no sense that a coherent understanding of the Credit Bubble is manifesting in Washington.

I could on a weekly basis come with dire predictions, but there’s more than enough of this type of reading available these days. I’ll stay focused on (contemporaneously) analyzing this historic Credit Bubble from every angle, with The Objective of Contributing to Lessons Learned. And I believe quite strongly that gleaning The Key Lessons from Major Bubbles is incredibly more challenging than one would ever imagine – that confusion, flawed analysis, ideologies and The Overwhelming Forces of Historical Revisionism create imposing obstacles to understanding. One can point to the 80 years or so of writings examining the Roaring Twenties and the Great Depression (what Chairman Bernanke refers to as the “Holy Grail of Economics”) to support this view.

There is no doubt the securitization and CDS (Credit default swap) markets were key facets of the Credit boom and are today at the heart of the devastating bust. Financial “innovation” always plays a critical role in major Bubbles – and this process of experimentation and innovation is consistently evolutionary in nature. While it is in many ways reasonable to cast blame upon these markets and their operators, Lessons Learned requires an understanding as to how these markets came to play such decisive roles. What critical features of the financial landscape contributed to the marketplace’s enthusiasm for these types of instruments? More specifically, how was it that Total Mortgage Credit growth surpassed $1.5 TN annualized during the first-half of 2006? How did asset-backed securities (ABS) issuance balloon to $900bn annualized in late-2006? How was it that Wall Street asset growth surpassed $1.0 TN annualized during the first-half of 2007? How could CDO issuance have possibly reached $1.0 TN in 2007 – and that the CDS market mushroomed to more than $60 Trillion at the very top of the Credit cycle?

The ratings agencies provide such easy and browbeaten scapegoats. They adorned “AAA” ratings on Trillions of MBS, ABS, and CDOs (collateralized debt obligations) during the heyday of the boom – back when home prices were forever rising, incomes were surging, Credit losses were disappearing, and New Era Babble was as unnerving as it was alluring. The rating agencies, Wall Street, Congress and virtually everyone else believed the boom was sustainable. But the radically-altered Post-Bubble backdrop now finds the rating agencies appearing as nincompoops complicit with shady Wall Street operators. Such a post-boom spotlight is predictable. From an analytical perspective, however, focus on the idiocies and malfeasance of the boom is certain to neglect key Bubble nuances.

From a “Moneyness of Credit” perspective, the Wall Street Credit mechanism evolved to the point of creating virtually endless debt instruments perceived by the marketplace as safe and liquid stores of nominal value (contemporary “money”). One cannot overstate the principal role top-rated debt money-like instruments played in fueling the Bubble, although let’s not get carried away and convince ourselves that the rating agencies had much at all to do with market psychology and speculative dynamics. For more culpable villains I suggest Washington look in the mirror. The “moneyness” enjoyed by Wall Street finance was either directly or indirectly underwritten within the beltway.

It was said back in the sixties that Alan Greenspan blamed the Great Depression on the Federal Reserve repeatedly placing “Coins in the Fuse Box” – repeated market interventions with the intention of perpetuating the 1920s boom. Going back at least to the 1987 stock market crash, our policymakers cultivated the markets’ view that Washington was right there to nurture and forever protect the “free” market. And the greater the prosperity and the higher asset prices went – the more certain the market became that policymakers would never let it all come crashing down.

The Greenspan Federal Reserve, in particular, nurtured the market perception that Washington was there to backstop marketplace liquidity. Greenspan pegged the cost of finance and essentially promised liquid and continuous markets. Mr. Greenspan became a leading proponent for securitizations, derivatives and “contemporary finance” more generally. “Liquid and continuous” markets were the lifeblood of these momentous Credit system innovations - and Washington seemingly delivered the goods.

Importantly, the GSEs – with their implied government guarantees – became commanding market operators and quasi-central banks, aggressively intervening to stem varying degrees of financial stress in 1994, 1998, 1999, 2000, 2001, 2002, and 2003. Congress was enamored with the virtues of deregulation, while turning a blind eye to the most glaring market distortions and excesses. Both sides of the isle were elated with the newfound capacity for the Federal Reserve and GSEs’ to jam Coins in our system’s “Fusebox.”

Congress steadfastly refused to address the issue of the GSEs’ implicit government backing, thus endorsing the most dangerous distortion to a “free” market pricing mechanism in the history of finance. All along, market confidence that Washington was backstopping system liquidity became more ingrained and problematic. Trillions of “money-like” agency debt and MBS securities were accumulated, with operators (and GSE “enablers”) cocksure that this market was much too big to stumble. The GSEs eventually did falter and were hamstrung by their accounting issues. By that time, however, the inflationary bias within mortgage finance and housing had become so powerful that the boom in Wall Street “private-label” mortgages/MBS easily supplanted GSE-related Credit creation.

This Credit boom – along with the GSE’s (and Fed’s) capacity for intervening to stem market liquidity crises – played a fundamental role as the market’s evolving perception of “moneyness” branched out to private-label mortgages and ABS more generally. Or, said another way: “No GSEs, then no uninterrupted Credit expansion; no rampant housing inflation and current account deficits; no massive global pool of speculative finance; no endless demand for perceived safe and liquidity mortgage securities of all stripes; and no evolving mortgage/housing/ABS/CDS Bubble.” There is plenty of blame to share with New York, London and elsewhere, but a strong case can be made that this was, at its core, A Washington-Induced Credit Bubble.

The securitization and CDS markets are the financial crisis’ current focal point. The markets’ misperception of liquid and continuous markets – that were instrumental in fueling the explosion of debt issuance and Credit insurance – has come home to roost in a very bad way. The securitization market’s basic premise was that the Creditworthiness of Trillions of Credit instruments would be supported by the capacity of borrowers to forever refinance and/or increase debt loads (Minskian “Ponzi Finance”). The basic premise of the CDS market was twofold: One, that contemporary securitization markets (backstopped by Washington) would provide borrowers endless quantities of inexpensive finance. And, second, that liquid securities markets would provide an effective means of (“dynamically”) hedging Credit exposures sold into the (“wild west”) CDS marketplace.

Today, those on the wrong side of the CDS market (having written Credit insurance) are getting killed and this dynamic is seemingly taking the entire system down with it. Corporate bond (bear) market liquidity is scarce, while the viability of scores of participants on all sides of the market is very much up in the air. This means that the hundreds of billions of default protection sold against troubled debt issuers (i.e. GMAC, Ford Credit, GE Capital, AIG, etc.) today confront a serious dilemma when it comes to hedging rapidly escalating losses (and unwieldy “books” of derivatives and counter-party exposures). Originally, the writers of this Credit protection would have assumed only a remote possibility that any one of a number of major institutions would default. They also would have expected that, in the event of rising default risk, short positions would be established in the bond market to hedge Credit risk. They wrongly assumed benefits from diversifying Credit risks, market liquidity and various forms of “too big to fail.”

Today, those on the wrong side of these trades and dislocated markets confront an environment that their models would have suggested was impossible: A domino collapse of major debt issuers in the face of near illiquidity throughout the corporate bond marketplace. During the boom, market participants would have assumed the opposite of an impotent Washington rummaging market wreckage for villains.

I’ll surmise that the CDS market is now in complete dislocation. I’ll also assume the sellers of CDS (and various Credit insurance) have resorted to shorting equities (individual stocks, ETFs and futures) in a desperate attempt to hedge escalating losses. This has likely placed additional pressure on sickly equities markets – and it goes without saying that it is especially damaging to market confidence when the stocks of our nation’s (and the world’s) major borrowers and financial institutions are all locked together in a death spiral. This dynamic has surely led to another round of forced de-leveraging. And, importantly, this type of market dynamic incites an acute case of “animal spirits.” While perhaps not as gigantic as before, the global pool of speculative finance (that accumulated over the boom) remains a force to be reckoned with. The dynamic of panic liquidations, de-leveraging and market operators seeking to profit from systemic dislocation creates a problematic deluge of selling.

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