Sunday, March 9, 2008

The Liquidity Crisis

As we appear to be hanging ten on the edge of a deep recession, getting the credit markets defibrillated grows increasingly urgent. Let's review, shall we?

First, we had a huge housing bubble.

As a consequence of that bubble, we had increased demand for sub-prime mortgages at the same time that the US was awash in almost free cash. Since there is universal agreement that increased home ownership promotes prosperity at all levels of society, there was zero complaint from either side of the aisle about lenders making loans with higher-grade risk. It was only later that these lenders became "predatory."

The spike in mortgages opened up new markets for collateralized debt obligations. Banks and other market-makers for credit gobbled these CDOs up at a furious rate.

The housing bubble burst, causing the value of the CDOs to become unquantifiable. In turn, this caused lending institutions to become very cautious with new loans until they understood the values of their portfolios. When the lenders got stingy with their money the dysfunction spread to all the other credit markets. This in turn caused businesses that depend on credit to cut back. Voila! Recession.

I hate the idea of government bailouts. If left to their own devices, the default rate on the mortgages backing the CDOs will eventually stabilize, allowing those securities to be properly priced and written down. Once that happens, the banks will start lending again and the credit markets will begin to function normally.

But that won't happen for a year or two. In the meantime, the economy is going into free fall. What can we do that will restore liquidity quickly? What if we go ahead and do a mortgage bailout?

The borrowers are better off. They get to keep their houses, if they want to.

The debt-holders are better off. They will be able to price the CDOs.

The businesses are better off. They can borrow again. The economy as a whole is better off.

The taxpayers are not better off, at least short term. Real money will have to be disbursed to support the mortgage market. It will have to be disbursed for two to five years.

On the other hand, the total liability to the treasury probably wouldn't exceed $200 billion. We just did a $160 billion tax rebate in the middle of a $120 billion-per-year war. $200 billion is a lot of money but it's probably a lot less than the losses that the economy will incur if it goes into a deep recession. (2% negative growth in a $12 trillion economy is $240 billion.)

The other loser, however, is the free credit market. It's politically impossible to do a bailout without enacting regulations that tighten the availability of credit to those with higher risks. That in turn will add some permanent risk premium to future interest rates.

This is a hard call, but I think a bailout is warranted. What form could it take?
  1. You could enact a foreclosure moratorium. Bad idea--this actually moves you further away from pricing the CDOs properly and prolongs the crisis.

  2. You can have the government directly subsidize people who are in danger of defaulting. Pricey, but probably immediately effective.

  3. You can have the government equity-share with borrowers, allowing it to recoup some of the subsidy when the home is sold. I suspect that this will result in freezing the housing market so that people don't have to pay back the equity. Another problem is that this is extremely complex; enforcement would be a problem.

  4. The government could provide bridge loans at a very low interest rate to people in danger of foreclosure. This would have fairness issues because people would in effect be rewarded for screwing up at the expense of others who borrowed responsibly. But it does have the nice property that the property is encumbered and the feds will get some of their money back, however discounted it might be.
I think I like option 4) the best.

Remember, this problem goes away once housing prices recover. If the properties have equity in them, the CDOs once again approach face-value, irrespective of whether the borrowers default or not. Meanwhile, the government guarantee props the CDOs up to face-value until the market recovers. I'd suspect that that recovery could take five years but that's a manageable period for a bailout.

Free marketers, hold your nose. It's the right thing to do.

No comments: