Monday, August 20, 2007

Credit Crunch

In my post An End to the Debt Bubble, I tried to organize my thoughts and present the big-picture synopsis of the events leading to the current market turmoil.

Over the last few days, just about every newspaper, blog and pundit has opined about the “credit crunch”. So, in the spirit of everybody else is doing it so why can’t I?, here’s my interpretation of what’s going down.

What Makes a Credit Crunch?
In a functioning market, there is a buyer for every seller. When you want to buy or sell GE, MSFT, or a T-Bill, there is usually always someone to buy or sell it to you.

Credit crunches and financial panics happen when buyers disappear, or when banks are unwilling to lend money to good credit risks. In the fixed income markets today, there are no buyers, at any price, for even the highest quality mortgages.

If a bank writes a mortgage greater than $417,000, they cannot sell it to anybody, so they have to keep the loan on their books. (High quality mortgages under $417,000 can be sold to Freddie or Fannie) Over the last few years, there have always been plenty of buyers of high quality mortgages – in today’s market, there are none. Thus, if banks can’t sell their loans, they are severely limited in the new loans they can write.

The crunch is not limited to mortgages. The market has broken down for any instrument that is not an obligation of the US Treasury. In fact, many money market funds, which typically hold all manner of high quality paper, are now exclusively buying T-Bills and not buying any commercial paper. For paper that still is trading, spreads have risen, making the prospect of selling more expensive.

Liquidity Crisis, NOT a solvency Crisis:
A typical Mortgaged Back Security will be a package of many different quality mortgages. As a simple example, it might have 75% prime, 15% Alt-A, and 10% subprime. As an absolute worst-case scenario, let’s assume that all of the subprime and Alt-A loans in this MBS default. So, instead of trading at 100, the bond is now worth something like 75 cents on the dollar. If the market were functioning as usual, there would be investors willing to buy the MBS at a price somewhere around 70-75. The owner of the MBS would certainly take a loss, but at least he/she could sell it to raise cash if needed. In the current market, there are no buyers at all and the few that are out there bidding very low – 45 or 50 to continue with this hypothetical example.

What is the Fed doing about this?
Essentially, the Fed and other central banks around the world are providing liquidity. Through their open market operations they are lending money to banks and accepting high quality mortgages and commercial paper as collateral. In effect, trying to function as the market would normally. This is not a bail-out – the Fed is not actually buying any loans, let alone anything even remotely related to subprime.

For sure, the Fed walks a tight rope when it pumps liquidity into the system because it can encourage risk-taking behavior and lead to inflation, etc. Here’s an interesting quote from Brian Wesbury, in today’s WSJ Op-Ed page ($link):

The best the Fed can do is to stand at the ready to contain the damage. In this vein, their decision to cut the discount rate and allow a broad list of assets to be used as collateral for loans to banks, was a brilliant maneuver. It increases confidence that the Fed has liquidity at the ready, but does not create more inflationary pressures. It was a helping hand, not a bailout.

It also buys some time, which is what the markets need. Every additional month of payment information on mortgage pools, and every mortgage that is refinanced from an adjustable rate to a fixed rate, will increase certainty and provide more clarity on pricing.

Even though many, including Alan Greenspan, continue to argue that the excessively easy monetary policy of 2001-2004 was necessary, it was this policy stance that caused the problems we face today. The current financial market stress is a result of absurdly low interest rates in the past, not high interest rates today. In fact, current interest rates are still low on a both a nominal and real basis. Cutting them again causes a further misallocation of resources, and makes the Fed an enabler of the highly leveraged.

Similarly, even very easy money today can’t put off the day of reckoning for subprime mortgage holders who bought homes with no money down and thought interest rates would stay low forever. It can’t help overly leveraged investors who thought they were getting risk-free 20% annual returns. Providing enough liquidity to allow markets to function, while keeping consumer prices as stable as possible, is the best the Fed can do. It should be all we really ask.

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