Treasury Secretary Paulson Comes Under Fire From Two Directions
A Big, Abrasive Man on a Small, Hot Seat
By blackhedd Posted in Economy — Comments (19) / Email this page » / Leave a comment »
Secretary Paulson hosts a meeting of finance ministers and central bankers in Washington this week. He's already being criticized bitterly by these people for not managing the US economy aggressively enough. (Their proximate concern is that the slide in the value of the dollar is hurting European exporters.)
On the other hand, he's been instrumental in encouraging players in the commercial credit markets to come up with a creative solution to the freeze which still afflicts this badly-damaged sector. For this, he's being attacked by highly-respected free-market ideologues.
Hank Paulson is a tough, aggressive guy who isn't afraid to make enemies. If you've ever done business with Goldman Sachs (which he used to run), you know what I'm talking about. One hopes that at least he's enjoying the fight.
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Check out some of the things the Europeans are saying ahead of this week's G7 meetings. From France's Finance Minister, Christine Lagarde:
Lagarde told reporters today in Paris that she will use her first G-7 appearance to talk about the need to ``avoid excessive volatility and disorderly exchange rates, which have unfavorable effects on economic growth.''
And Japan's Finance Minister Fukishiro Nukaga:
``Ordinary moves in the currency and other financial markets are important for stable economic growth, and we will focus on this issue'' at the meeting, Nukaga said.
This is very mild stuff. What their underlings have been saying to the press in the last few days is more along the lines of: we're all disgusted that the Americans, starting with Paulson, aren't willing to manage the US dollar higher. Statements by the Germans, who are feeling the heat of high inflation, have been even blunter. The economies of Japan and Europe (especially Germany and to a somewhat lesser extent, France) are heavily export-driven. The weaker dollar, which has resulted from lower short-term interest rates in the US, makes everyone else's exports more expensive for Americans to buy.
But Paulson (who has been in his job since 2005) is following the policy of the Bush Administration generally, which not even once in six years has intervened in foreign currency markets. Paulson has said on many occasions (and he reiterated this week) that a strong dollar is in the best interests of the United States. But remember, no one knows markets like he does. Given a choice, you can generally expect him to let markets do their thing.
And that brings us to a different problem: the commercial credit markets, which are still reeling badly from the Subprime Crisis that roared through the financial world in July and August.
The multi-trillion dollar market for short-term borrowings by businesses ("commercial paper") has been nearly stagnant since the crisis began, and continues so to this day. This is putting a big hurt on plans for business expansion, and indeed the news background this week has been full of stories about lowered growth expectations around the world.
In short, Secretary Paulson has put his weight behind a plan by three of America's largest banks (Citigroup, Bank of America, and JP Morgan Chase), to establish a syndicate to purchase commercial paper that is backed by securities with exposure to subprime mortgage assets.
The new vehicle (which is being called a "Master-Liquidity Enhancement Conduit," or M-LEC, a name that's silly even by Wall Street standards) will be funded with at least $80 billion contributed by the three large banks that are setting it up.
Treasury Department officials, especially Robert Steel, have been instrumental in getting Citi, BofA and Chase to the table and keeping them from lunging at each others' throats long enough to put this deal together. That image should remind you of the efforts that officials of the New York Fed made in September 1998, to encourage Wall Street to liquefy Long-Term Capital Management and prevent a market meltdown.
The reason for three large institutions to commit to putting a floor under the asset-backed paper market is this: Something like $320 billion in outstanding securities may be dumped on the market all at once if they don't. And that would cause a global meltdown that would make last summer's liquidity crisis look like the proverbial game of badminton.
So what's the problem? Well, the plan is being presented as a bailout. Even the Wall Street Journal's editorial page jumped into this interpretation:
Treasury officials' involvement was panned by the Wall Street Journal in an editorial today. ``The less-good news is that Hank Paulson and the Treasury seem to have gone out of their way to leave their fingerprints'' on the plan, the Journal said. Paulson ``better make sure the banks aren't using him to delay their day of reckoning,'' the paper said.
Paulson said in a speech in Washington today that he has ``no interest in bailing out lenders or property speculators'' and announced that the Bush administration will review accounting rules for banks' off-balance sheet units.
Steel stressed in an interview in Washington that no federal money was involved in the fund, which he described as a temporary solution to help markets recover.
I haven't seen any indications anywhere that the M-LEC will contain any public money. There's no bailout here. And yet, the redoubtable William Niskanen of the Cato Institute weighed in with this:
``It is disappointing,'' said William Niskanen, chairman of the Cato Institute in Washington and a former member of President Ronald Reagan's Council of Economic Advisers. ``It does go against the Bush administration's preferences. Like all bailouts, it creates a moral hazard problem. I'm unhappy with situations like these.''
Plenty of other credible voices around the Web are saying basically the same thing. And these are the good guys, people who are committed to free markets.
But from where I sit, this doesn't constitute an intervention in free markets. Rather, it's a warranted response to a severely disordered market. What Steel and other Treasury officials have been doing is to encourage players who are competitive with each other and have divergent interests, to come together in a way that will benefit everyone, by providing liquidity to a market that badly needs it. This situation probably can't be improved any other way. Paulson and his team are doing the right thing.
So in sum, the Treasury Secretary is having one of those weeks. What really concerns me is this: the United States is now in a very weak negotiating position because our economy is faltering, compared to those of other countries. In dealing with the G7 finance ministers and central bankers, Paulson is going to have a much harder time than in the past, when he tells them that he's not willing to intervene in the currency markets, as they would have him do.
Already he's making some very uncharacteristic noises, talking about how regulators will need more "transparency" into off-balance sheet investment vehicles and financial innovations. He's obviously feeling the heat.
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They're the holders of most of the commercial paper that is causing the concern. A SIV is an investment product that is typically created by a bank. As far as I can piece together, Citigroup has been the major syndicator of these things.
The various people who are yelling "bailout" are assuming that the mortgage-backed assets that secure the commercial paper issuance are impaired as regards credit quality. But this is almost certainly not the case, not for the vast majority of them, anyway. They most certainly are impaired in regard to their liquidity, which is of course a very different problem.
That's why the market needs someone to step up and buy them. And since the banks that issued the original SIVs stand to be hurt the most if this market collapses, who better than they to put their money where their mouths are?
So, if I understand you correctly, the new fund set up will be used to make a market in these securities. Why can't the SIV's make a market in the securities without this new fund?
The various people who are yelling "bailout" are assuming that the mortgage-backed assets that secure the commercial paper issuance are impaired as regards credit quality. But this is almost certainly not the case, not for the vast majority of them, anyway.
I understand the liquidity impairment as part of the problem, but if housing prices are falling, and houses are the principal assets underlying these securities, how could mortgage-backed assets not be impaired pertaining to credit quality?
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And statesmen at her council met
Who knew the seasons when to take
Occasion by the hand, and make
The bounds of freedom wider yet
- Tennyson, _To the Queen_
Well, more precisely, they're owned by the buy side. They don't make markets.
Houses are not the assets underlying asset-backed securities. Mortgages are. As a rule, homeowners are among the most creditworthy debtors there are, because if you let your personal credit rating go, it messes up the rest of your life. And even if your home's value falls, you're not going to get a margin call. So you'll generally stay put and keep paying the mortgage.
That theory, along with some super-sophisticated financial engineering, are why many tranches of mortgage-backed securities have been issued with investment-grade ratings over the last few years.
The collapse in issuance of mortgage-backed securities is a very complex phenomenon with a lot of moving parts. I have my own theory of what happened, that doesn't involve any great deal of malfeasance by bankers, borrowers, or rating agencies.
But the mere fact that there is no liquidity in this market, quite apart from the credit-quality issues, is enough to keep most fiduciary investors out of it. (That's just basic portfolio theory. You can't properly value an illiquid asset, so you can't hedge it. If you can't hedge it, you're not allowed to own it.)
When the spillover effect is to the commercial-paper market, as it is in this case, then you've just created a channel for a financial-market disorder to get communicated to the real-world economy. That's deeply frightening.
"subprime crisis" I've seen yet. It sure beats the talking heads on CNBC....
Socialism doesn't work. It looks nice on paper, but it's been tried and it's failed miserably every time (usually accompanied by widespread death and suffering).
Proud member of the V.R.W.C.
Which makes plenty of sense, since they are the ones who would take it on the chin.
"No compromise with the main purpose, no peace till victory, no pact with unrepentant wrong." - Winston Churchill
Thanks for clearing that up. However, there has been much ado about banks' lowering their credit standards for mortgages and not requiring proof of income. So with the influx of ARMs and lesser qualified borrowers in the market, this should adversely impact the collectibility of the debt. Furthermore, this is evidenced by the recent calls from the Fed and Treasury for banks to refinance ARMs with fixed rate mortgages to ward off default. If default risk has increased, raising the uncertainty of future cash flows, how could this not affect credit quality?
In addition, in the case of default, it seems that MBS holders stand to lose significantly despite the forclosed collateral, because in addition to administrative/agency costs in liquifying the assets and the fall in market prices for that property, the average time a house stays on the market has increased, requiring the MBS holder (or their agent) to do one of two things: hold onto the property longer than desired to reap maximum selling price or sell at a deeply discounted price to serve their cash flow needs. How could these issues not affect the credit quality of MBS?
I am not too familiar with the details of MBS and I suppose it is possible that MBS holders are insured somehow against liquidity issues in the housing market, so I may be off on this. But this is my first reaction.
Thanks for your posts. I am a student studying finance and enjoy reading your thoughts on the working of our markets.
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And statesmen at her council met
Who knew the seasons when to take
Occasion by the hand, and make
The bounds of freedom wider yet
- Tennyson, _To the Queen_
As a follow up, this was in the WSJ today:
Behind the market turmoil of recent months: Lending standards were more lax than most people imagined, a fact that surfaced when house prices stalled.
...snip...
Should house prices fall by 10% over the next two years -- an outcome analysts see as entirely possible -- losses stand to be staggering. Thomas Zimmerman, head of mortgage credit research at UBS in New York, estimates that in such a scenario losses due to defaults could wipe out as much as 16% of the nearly $600 billion in subprime-backed securities issued in 2006. In August, such losses were equivalent to less than 1% of the total.
I understand your point that MBS use mortgages as the asset, not houses. But since the risk inherent in mortgages, and therefore their value, are reliant on the value of the collateral pledged and the likelihood of default, it seems that this would decrease the value of MBS and create risky assets, and could thus be considered an issue of credit quality. Didn't something need to cause the liquidity crisis in the first place--some shift in thinking concerning the value of a MBS (or the inability to ascertain value)?
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And statesmen at her council met
Who knew the seasons when to take
Occasion by the hand, and make
The bounds of freedom wider yet
- Tennyson, _To the Queen_
...in late spring ultimately had their origin in credit quality concerns, but the amount of credit impairment was (and is) quite small. I vaguely remember that default rates on subprime mortgages (which total $1 trillion give or take, a relatively small part of the total market) went from 0.1% to maybe 0.5%.
The real problem was different. Securities backed by mortgages are illiquid, just as houses themselves are. And it turns out that the valuations of these securities were coming primarily from new issuance, since there was never an active secondary market for them.
Well, new issuance of mortgage-backed securities came to a screeching halt sometime in 2006, along with the growth in housing prices. Now there were essentially no pricing signals in the market at all, but holders of asset-backs (including thousands of banks, hedge funds and other institutions all around the world, with a surprisingly large concentration in Europe) were comfortable with the valuations they were carrying.
Then when default rates crept up this year, there was naturally a desire to revalue asset-backs accordingly. (I believe this was part of a considerably larger trend that appeared early this year, in which risk of all kinds was systematically repriced.)
But there was no new issuance and no secondary market! So practically there were no bids for any of this paper. If you can't find a buyer for something, you have no idea what its value really is. All you know for sure is that you don't want to own that security.
If you happen to be heavily leveraged, as many hedge funds are, then wanting to sell a given security takes on a whole new meaning. You will sell at any price you can get, and crucially, you'll sell assets in unrelated classes in order to get liquid.
That was the genesis of the financial crisis. The explosion came in early August (the 8th, if I recall correctly, it was definitely a Wednesday), when a large French bank announced it would halt redemptions from a major fund, because it had no idea what the value of the asset-backed securities it held actually was.
I smelled it brewing back in May and early June, when word started leaking out that two large hedge funds at Bear Stearns were trying to get liquid. Instantly the memory of 1998 clicked, so I knew what was going to happen. I was right.
Thanks for clearing this up.
I smelled it brewing back in May and early June, when word started leaking out that two large hedge funds at Bear Stearns were trying to get liquid. Instantly the memory of 1998 clicked, so I knew what was going to happen. I was right.
I hope you invested accordingly. Goldman did, and they reaped a handsome profit.
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And statesmen at her council met
Who knew the seasons when to take
Occasion by the hand, and make
The bounds of freedom wider yet
- Tennyson, _To the Queen_
What are they doing to do if we don't meddle in the market ot their liking? Run the printing presses? Raise taxes on themselves? Send troops?
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Let's nominate the Nash Equilibrium for President.
They could selectively protect against certain imports from America. The political pressure inside of Europe is massive right now because of their high inflation. Remember how it works in Germany: the labor unions have a seat at the table whenever anything important gets decided, and their wages are the ones under threat. And in France, Sarko and Lagarde have been sniping about high interest rates ever since he took office.
Until this past summer, everyone was expecting another increase in euro-rates to damp the high inflation down. Now we just went and cut our rates, which puts the Europeans in a nasty box. They can raise rates and annihilate the dollar and their own exporters. Or they can cut rates or stand pat, and trigger even more inflation.
When you're desperate like that, you do desperate things. The fact that they don't owe us a whole lot right now (because of our weak economy) makes Paulson a good target.
Japan is facing a pretty serious slowdown too, for reasons of their own (bizarre changes in building regulations), on top of their export-led exposure to our economy.
It's bad out there.
Let them cut off their own noses. Why do we care?
HTML Help Central for Red Staters
Let's nominate the Nash Equilibrium for President.
Our own export industries are pretty much the only thing in America that's growing. Let the Euros damage that, and in addition to the economic pain, it also makes the Democrats look better.
The financial world and the policymaking community are small and tight-knit. They also consist of very big boys and girls who play hardball all day long. Whoever is in a strong position at any given point in time will make the rules, and everyone's relative position shifts over time.
It just doesn't work to let everyone else go their own way. Everyone is too interdependent for that.
That's exactly what I mean: If all these economies are interdependent, then what can they do to try to hurt us that won't also hurt them?
It seems to me that the only way a trade war ever actually accomplishes anything, is when it's done in a way designed to manipulate the domestic politics of the targetted country.
Well, at this point President Bush has absolutely nothing to to lose, so...
HTML Help Central for Red Staters
Let's nominate the Nash Equilibrium for President.
Sounds like the Europeans that have the high taxes and are most protectionist, France, are crying the loudest. Where was that IBDeditorial that talked about the flat tax? In many of the European countries, anyway, those countries are doing fine and growing quickly with flat taxes from 23% down to around 10%.
Currently the USA Fed target rate has been 4.75% and the ECB has been 4%. The Euro has risen in expectation of higher rates and the talk of diversification out of the US $ thanks to the G7 meeting a couple of April's ago. Maybe its time for the Europeans to start thinking about supply side taxation so that they get the productivity they need to get from their people like what the American employer's get instead of blaming an American for European problems.
In as pedestrian language as possible.
I have been following the housing crash since 2003, when it was still in boom form.
I'd disagree with Blackhedd about the default data for mortgages, but I only have San Diego as a sample, so I may be wrong about this. San Diego defaults are up over 1400% since 2004. That's right, 1400%, and 800 year-over-year. You should take a look at the graph. We are talking "log curve" here. The proverbial doo doo is hitting the fan.
Now stating that, home prices are crashing. Median price is so inaccurate as to be laughable, and even case-schiller doesn't take into consideration all the remodels done since the boom began.
Home prices in so-cal and many western states are in absolute freefall.
How does this relate to the SIV's? They are backed by mortgages. Mortgages are backed by homes. When mortgages default, the value of the SIV's, CDOs, etc (for now, lets disregard "tranches" to make this simpler) are simply the house itself, plus the cost of listing and selling the foreclosure.
Thus, when home prices crash, and neg-am, no-doc, 100% financing carrying speculators (AKA everyone in so-cal paying ludicrous money for a house) stop paying their mortgages - and they are - these SIV's are rendered worthless.
As for Blackhedds comment about their being no market for SIV's: There was a market before, they were bought when liquidity was there. Much of that liquidity came from the SIV's value increases, in other words, part the housing bubbles fuel. It's not that there isn't a market, it's that the market is
A: broke
B: not stupid, and knows the SIV's are near worthless
C:All of the above.
This plan to purchase the SIV's is a delay tactic, before the large banks lobby for a government bailout. The banks know if the SIV's get put on the market, they will sell for pennies on the dollar, firms will lose TRILLIONS "marking-to-market." This would be a catastrophe, and would most likely lead to a giant credit crunch that no one wants.
By rounding up all these worthless investments into one vehicle, and overpaying for them, it gives everyone the sense that everything is OK. Life goes on, until those assets are "marked to market." That word is going to become quite common on the news in the near future. The models were wrong, Blackhedd. Very wrong. And one day, either the banks will eat the cost or the responsible taxpayers will. And if you think voting republican will prevent this bailout, think again. The power wielded by these banks dwarfs a puny vote. They will hold these SIV's until a bailout is orchestrated.
PS: This is more stream of though than anything else. I'm no economist, and have no college degree. I claim no right answers. This is merely what I think, based on a few years of reading off the net.
You say that mortgage defaults are up 1400% in your area. Blackhedd said they increased from .1% to .5% or up 500% on nationwide numbers. I have several comments on these numbers:
1. You're in California which has magnified the housing issues see elsewhere. Your growth rates were higher on the way up and your rate of value drop is going to be higher on the way down.
2. What was your default rate in 2004? .1%? Giving that a 1400% increase still makes the default rate only 1.4% which is still a SMALL number compared to the overall number of mortgages. Small numbers can cause scary looking stats if you look at them wrong.
3. Blackhedd was speaking about the mortgage back securities over all default rate which are national numbers, not area specific. Housing can be a VASTLY different market in different areas of the country. There are still areas where prices are going up and many other areas (like my own) which are remaining mostly unchanged.
Socialism doesn't work. It looks nice on paper, but it's been tried and it's failed miserably every time (usually accompanied by widespread death and suffering).
Proud member of the V.R.W.C.
Yeah. I totally understand what you are saying. I get the feeling things aren't nearly as bad across the US. California is a huge market, and full of idiots. I wonder how much effect it will have when averaged against markets that aren't quite as reeling as my own.
That's why I put the disclaimer at the bottom. I believe AZ, NM as well as FL are in a similar boat, and wonder what the total % of houses sold between 2002 and 2007 were sold in those areas.
Be interesting to know. I usually don't post much on this site (use it as more news then anything else), but this topic really hits home for me. I'd do anything to stop a bailout, whether paid for by taxes or deficit.
-freedom
Who will do the dumping? Are there that many hedge funds still facing large withdrawals that they will need to liquify their assets?
*********************************
And statesmen at her council met
Who knew the seasons when to take
Occasion by the hand, and make
The bounds of freedom wider yet
- Tennyson, _To the Queen_