FYI | Mar 13 2008
By Greg Peel
President George Bush provided a rare television interview on US television last night. We can only surmise as to why such interviews are rare. On the question of whether the US was in a recession Mr Bush answered in the negative, while admitting that times were nevertheless tough. Said Bush:
“[The US is not recession] because there’s a definition for the R-word, and we haven’t reached the definition.”
Comforting indeed. What Bush is referring to is the fact the long held economists’ official definition of a recession is two consecutive quarters of negative growth. The fourth quater US GDP growth figure came in at an annualised +0.6%, which means both the first and second quarters would have to be negative before a recession can be officially declared. As it then takes a while to compile the GDP numbers, it would be August before the truth could be known. The first quarter numbers would provide a clue if they are, indeed, negative, but still we’d have to wait for the second quarter to be absolutely sure. At least that’s what Mr Bush’s reckoning implies.
Never mind that the +0.6% figure in the fourth quarter represented a fall from +4.9% in the third. And never mind that economic data have only been more ominous ever since, largely supporting a stagflationary scenario. Stagflation requires a slowing economy with rising inflation and rising unemployment. All those boxes have been ticked lately. The trend fall from Q3 to Q4 looks pretty definitive by anyone’s measure, and there is little to suggest Q1 won’t show an acceleration to the downside.
But it’s the role of any politician to be upbeat in the face of disaster. One recalls the wonderful statements read by Saddam’s PR man “Comedy Ali” in Baghdad, who suggested the Americans had fallen at the gates of the city, while behind him US tanks were rolling by with “Hi Mom” signs attached. When asked what measures Mr Bush would take to fix the US economic “tough patch”, he replied:
“Oh gosh, it would be more than one. It would be to speed up the excess inventory of houses so that the housing market would get back on its legs. But I’d also like to see that price of gasoline drop a significant chunk”. (Marketwatch.com)
Why do the Canadians suggest their country is only separated from the US by a thick bush?
The US Federal Reserve is also, on the face of it, denying a recession. While its most recent growth forecasts were lowered, they were still around a +2.0% average. But given what the Fed has been throwing at the financial markets lately, one can only assume this forecast is based on a belief that whatever the Fed must do it will do, and that this will prevent a recession (in the technical definition). The Fed is now beyond denying it hasn’t acted swiftly and succinctly to date, nor that it has misread the market so far.
And so it was the Fed finally took a step along the credit distribution chain on Tuesday, instead of just throwing more liquidity into a black hole or making another emergency rate cut and sending the US peso ever lower. Actually one should no longer mock the peso as a currency, given it’s looking a lot better than the dollar these days. To understand what the Fed did, one has to go back to the original subprime daisy chain.
A hedge fund sets up a structured investment vehicle (SIV) with one million in capital and goes to an investment bank and asks for a ten billion dollar line of credit to provide security to invest only in AAA-rated securities. The bank does not even lend the actual money, for the SIV borrows that from the short term AAA commercial paper market on 30,60,90,180 and 365 day bases. The bank charges 3 basis points, and the commercial paper costs another 3 basis points. The SIV then invests the money in AAA-rated CDOs – a tranche of warehoused and securitised mortgages which offer much better than 6 basis points of return. Bada bing, bada boom – you could do this forever. AAA to AAA on a positive spread.
But when the housing market turns down, the subprime mortgages forming a small portion of the CDO default, affecting a drop in price of the CDO. Suddenly its realised that if enough mortgages default the whole CDO is in jeopardy. Sell!
But to whom?
The hedge fund goes under. The commercial paper loan is unpaid. The bank provided the security, so its now stuck with the collateral. It tries to sell the distressed CDOs, but still no one will buy. And guess who created the CDO in the first place – the SAME BANK. The bank has, via a complex daisy chain, leveraged itself. Funny money. And as they say, when the music stops, there aren’t enough chairs.
Where do all these funny money losses still lie? We still have no idea. These are not exchange-traded instruments. They trade in an over-the-counter market, off balance sheets and, until recently, with little accounting requirement. They typically have maturities of five years, meaning that while some are reaching maturity now, those created in 2006 will not mature until 2011. Some may make it through to maturity, some may fall. This depends on the ability of the original mortgage holders to make their payments, and on the number of ultimate defaults. The latter number is increasing as housing values fall. The daisy chain, which fed on itself, is now feeding back the other way. That’s why this financial crisis is a slow death, not a one-day crash like that in ’87, or even a rapid revaluation like the 2001 tech wreck.
This is the worse financial crisis since the Great Depression. Some see it as being worse than the Great Depression.
The Fed could have done one of two things. It could have done nothing, meaning it would let the evaporation of funny money take its course and allow the greed-driven hedge funds and mortgage lenders and investment banks go under, thus providing a return to normal risk-pricing and the welcome survival of only the prudent. But while this would be the morally responsible approach, relistically the US (and thus global) banking industry would collapse and there would follow an economic nuclear winter where every citizen would see suffering.
So instead it decided to reflate the frozen credit markets by pumping billions and billions of dollars into the system by cutting the cash rate and by reducing the cost of borrowing directly from the Fed. It didn’t work – things only got worse. It then broadened the range of securities which could be put up as collateral by the banks as a swap for short term liquidity, and it increased the loan maturity. It still didn’t work. It was giving money to the banks and, in fear, the banks were simply not giving it to anyone else.
For one must understand that the Fed can only provide support to “commercial”, deposit-based banks. For its simple role is to stop runs on the banks and protect deposits. It is not their to support the activities of the capital markets and the “investment” banks or brokerages that are active in them. But obviously the capital markets represent trillions upon trillions of money flying around, so the Fed cannot ignore the connection. Its activities to date had relied on the commercial banks passing liquidity onto the investment banks who would in turn pass onto the mortgage lenders and the credit collapse would be stabilised. But as if the commercial banks were going to throw good money after bad. You might as well give your life savings to an addicted gambler on the belief he could gamble his way out of trouble and then give it back.
However, the Fed decided on Tuesday it was time to expand its horizons. About time, said many. Having provided $200bn of liquidity to the commercial banks last Friday via an auction, only to see the markets keep tanking, it took a step along the chain on Tuesday and offered liquidity straight into investment banks, brokerages, and any other “primary dealers”. These are your Citis, Bear Stearns, and even your Countrywides, although not all mortgage lenders are primary dealers. Thornburg is not, for example, so there is yet another step along the chain which may yet not be facilitated. But this was a case of getting liquidity to the source – supplies to the troops – blood to the heart – however you which to put it.
The process involved allowing primary dealers to exchange their AAA-rated mortgage-backed securities, which includes government sponsored Fannie and Freddie mortgages, prime CDO tranches etc but not subprime toxic waste, for US Treasuries. While subprime was where it all began all mortgages – no matter how secure – have been no-go zones in 2008. The swap will last only 28 days to provide a stabilising breather for the market, but the hint is the Fed could keep on rolling. The Fed is not allowed to buy mortgages directly, but this is the next best thing. And it was a coordinated effort with central banks in Europe and Canada.
So has this solved the problem? Will credit markets reopen, bank cost of funds fall, house prices stop sliding and the stock market take off again?
No. It’s just another bandaid on a broken market. The London Daily Telegraph’s Damian Reece summed it up nicely:
“Arguably, having come this far, Mervyn King [Governor of the Bank of England] and Ben Bernanke have breached the point of no return. There is no going back. The US certainly is now relying on its central bank to keep its most important credit markets open and its equity markets from plunging and to bring a veneer of normality to financial life. Traditional supports, such as confidence in normal commercial debt repayment, have been knocked away as institutions are engaged in a desperate dash for cash.
“While the Fed is willing to slash rates and hope, and pump liquidity into the system, markets will remain optimistic. But it is a race to the bottom, the Fed hoping it reaches the finish line first and restores confidence returns before a bank goes bust. But the spectre of a collapse is neck and neck with Bernanke and it’s still anyone’s guess which will win.”
