BAILOUT OF WALL STREET FROM HOUSING COLLAPSE

ON MAIN STREET - September 28, 2008

ARE CAPITAL MARKETS IN BLACK HOLE SPIRAL?

The US Congress and Executive now debates the final terms of a still presumed "bailout," necessary, well focused or not. The credit squeeze and deflation certainly pose the danger of becoming the black hole swallowing good and marginal risks. Housing is at the source of this gravitational downward pull and will have to be at the front of any resolution. Whether this is recognized within the "financial bailout" remains to be seen.

The black hole analogy is especially fitting: Those caught in the downward spiral may have no moment of reference to make rational decisions. Grasping for what appear to be appropriate options in the now may in fact already be in the past and beyond reach.  (See Lehman Brothers, AIG and Washington Mutual). The wise will recognize that every future option will be less favorable than the one offered now and just possibly may be agile enough to grab hold. (See Merrill Lynch). On the other hand some may not even be capable of perceiving their point of reference as they are sucked toward zero. Of course, this scenario is also the perfect physics for panic.

EXASPERATING THE DOWNWARD SPIRAL, STOPPING IT

The fact that it was housing that started the collapse is not a particularly novel notion by now. AIG, the behemoth of global finance was rescued from bankruptcy with an unprecedented bridge loan of $85billion from the US Federal Reserve, (NY), and this presumed reprieve is welcome by many who feared the tsunami that such a collapse could have caused. There has also been a vast infusion of liquidity by key central banks the previous week, also intended to ward of catastrophe. Finally new rules, in Europe and US, may deter speculative and/or manipulative short selling. Whatever solutions to decisively break the grip of this black hole, they have to converge upon ending housing value erosion as well. (Alan Greenspan, former Federal Reserve Chairman and perhaps also to some degree responsible for this predicament, has pointed to the stabilization of housing values as best indicator of the bottoming out of this crisis as a whole). While housing is at the center, though, there are other more or less related factors that are accelerating, exasperating the inward spiral:

Credit Crunch:

Lending is sparse or not available for new financing or the refinancing of current debt coming due. This certainly has an impact on leverage and profitability. (Infusions of liquidity by central banks do not necessarily reverse the credit shrinkage). More critically though, it can precipitate otherwise sound projects and ventures to face a liquidity crisis, and ultimately bankruptcy. Business fundamentals are no longer a sound point of reference. This perspective is propelled by the uncertainty within financial institutions, lack of appetite for almost any risk, and a regulatory environment in effect working in contradictory directions.  

Regulatory Rear View Mirror Approach:

The regulatory response has been too much defined by the rear view mirror.  The issue is not necessarily too much or too little regulation. Rather, the reaction has too frequently been impulsively reactive, reflecting the previous lapse rather than the challenge ahead. The credit crunch is at least in part a response to new regulation exasperating previous lapses or inadequate oversight. In the face of such regulatory driven armadillo like tactics, credit rate loosening has limited impact in halting the downward spiral. (We warned in our previous articles, "US Economy: Recession or Transition" and March 1, 2008, "US Economy: Phoenix Rising or Wounded Duck Flying?" as well as July 24, 2008, "Rearranging the Furniture While the House is Foreclosed Upon", that "rear view regulation" was exasperating the downward spiral of a housing crisis neither fully understand in its it breadth, depth or socio-economic implications).  

"Mark-to-Market":

This is a regulatory driven accounting practice whereby institutions are required to value assets on their books by the then current market price. This is problematic if market prices are formed by market distortions or lack of liquidity. It is of doubtful legitimacy, especially if the underlying asset in question is performing, of a longer duration or cannot be priced in conventional market environments. "Mark-to-market" is perhaps a good example of regulatory provision that may be ill-suited for the desired end and in fact have counterproductive consequences. It can have the effect of propelling a fundamentally sound long term asset into the relative warp speed of short term assets for financial analysis purposes and even cause institutions to liquidate such sound assets at scavenger prices. This creates the probability for panic, the possibility for self fulfilling disasters and the real opportunity for abuse.

Regulatory asymmetry:

While inadequate oversight may have contributed to the current problem, including in housing, the capital markets have become a convergence of over-regulated, under regulated and non-regulated institutions. The effect may be to compel some participants to enter with butter knives while others are free to wield axes. Regulation not only has to consider self inflicted wounds from sharp objects but hacking from non-regulated participants that can act as marauders.

Speculative and Manipulative Abuse:

The asymmetrical regulatory environment can only exasperate the opportunities for and actual abuse through market speculation or manipulation. Further, the potential "abuse" or at least hacking at the pre-designated prey can occur with an attack upon the stock price of the stalked institution, upon the then presumed "market price" of the assets of this institution or just upon its perceived reputation or relative invincibility. (President Bush, has now also highlighted the need to address "speculation" in the regulatory response, and it is indicative that the US as well as Europe have now focused on stemming potential abuses in short selling). 

Equity Price Volatility:

Equity price does not necessarily reflect balance sheet or credit risk. It has come as a bit of a revelation though that equity price volatility can affect the credit risk associated with a particular company. Simply put, the ability of a company to raise additional capital and reduce leverage and risk may be severely bounded by its equity price. This is decisive to survival as the global business community is undergoing de-leveraging. The capital markets have a predatory element which is largely constrained by fear and the size of the prey. When a capital markets elephant, such as AIG, (American Insurance Group and world's largest), suddenly shrinks to the size of a warthog it can become ready prey to lions and jackals, and fear is only founded to the extent of intervention by outside or regulatory factors. Worse, even the elephant may not yet see itself as the warthog or the sudden danger.

BACK TO THE RATING AGENCIES

Standard & Poor's, Moody's and Fitch have had a lot of blame leveled at them for the collapse in mortgage backed securities and not being vigilant enough to alleged abuses. (It is not certain that rating agencies can be expected to identify fraud or abuse, while it is more realistic to expect them to be sensitive to potential market disorders and unhealthy trends). Ironically now the rating agencies are again playing a critical role in the life and death struggles of institutions such as Lehman Brothers, Washington Mutual, AIG and various bond insurers.

A rating can determine credit cost or even availability of credit in the current treacherous period. A rating could be decisive in the negotiation of credit terms, especially when liquidity bridges are an important tool of survival. Most critically, a change in rating by one or more of the major rating agencies could trigger an "event" affecting beyond just credit issues but also underlying business contracts, (as with AIG and its policies).

Perhaps this would all function with some sense of order under normal conditions or even those characterized by momentary market displacements. However, when considering the rating of institutions, (such as AIG), Standard & Poor's, Moody's and others went beyond the balance sheet. They determined that equity price drops were constraining ability to raise additional capital and potentially needed flexibility. It is not comfortable for rating agencies that are familiar with credit analysis to anticipate equity price movements, asset prices, (driven by "mark-to-market" accounting), and to distinguish longer term valuation changes versus such triggered by temporary market disruptions, panic or manipulation. While rating agencies may have been slow to recognize potential disorders in the mortgage backed securities market, will they be compelled to react prematurely to volatile movements in transitory prices of an institution's stock price or the multiple assets in its portfolio? (AIG was not insolvent, but had to be salvaged by US Fed bridge loan due to liquidity considerations, mark to market valuations and a run on its equity price, as well as further potential downgrades by the rating agencies). Further, unregulated "credit swap" markets, now a critical component to survival by capital market participants, may reflect totally different risk profiles than rating agency analysis, perhaps due to greater insight or manipulative, predatory behavior.

IS DEFLATION THE EMERGING ENEMY AND REFLATION POTENTIAL SAVIOR?

Inflation may have been yesterday's danger, but tomorrow it will be deflation. Asset prices, such as oil, metals and food, rocketed upwards, and it is pretty clear now that this was done in part to excess by speculation or even manipulation. (While demand was certainly growing from developing and developed markets again the potential for abuse may have become reality in some of the spikes: See our June 8, 2008 article: Energy Price Manipulation?). The speculative bubble had to burst, especially faced head on with economic contraction. Now, the danger is that the credit crunch and even liquidity constraints as well as economic contraction will continue to sharply propel all asset values down, including housing which has been already especially hit hard. It is no longer the "sub-prime" mortgage that is at risk. Most of that has already been wiped away. Now it is the average homeowner who is holding a "conforming" or relatively conservative mortgage. The current mortgage and housing crisis is now approaching or possibly exceeding, (depending upon the measure viewed), Great Depression era devastation.

"Reflation" is the notion of excess liquidity driving up the prices of all assets and the appetite for risk. It is the notion that has been frequently associated with the "bubble" that is currently imploding, from housing to oil. In the early part of this decade, presumably in response to the September 11 terrorist attacks and the potential seizure of capital markets and the US economy in general, the Federal Reserve under Alan Greenspan led central bankers around the globe to create more, perhaps excess, liquidity, and provide credit on the cheap.

Today the trend is different, toward less leverage and debt. That is probably positive in reducing risk and adding capital flexibility. This still though does not address the concern of at least one asset class, housing, being driven down by the credit crunch and related factors. While "reflation" may not be an option that the US economy may want to revisit, undoubtedly some level of inflation may be necessary to bail out the homeowner and those holding mortgages. (Commercial properties and REITs seem to be stabilizing or rebounding, perhaps already an indicator of inflation as inevitable ending to this crisis). It is certainly better to err on the side of inflation than deflation, as evidenced by the experience of the Great Depression or even the more recent deflationary stagnation of the Japanese economy. 

"WELCOME TO THE JUNGLE!"

Predation is a part of capital markets behavior. However, the above "Guns 'N' Roses" blue collar song title should be hanging at the entrance to Main Street as well as Wall Street. While there is cannibalism at the top of the capital markets food chain, at the Main Street level there is the most pain. For certain, there will be some big winners along with the many losers, (and the bailout of Fannie Mae and Freddie Mac should have some trickle down to the middle class). As the US Congress now evaluates a more comprehensive bailout, (including a purchase of illiquid assets), of hard hit financial institutions; however it's Main Street that will be bleeding for some time. We will save comment on the bailout until we see if the final package touches more directly upon the average citizen and housing. 

Muhamed Sacirbey

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Author of the article is a former Vice-President of Standard & Poors.

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