February 17, 2009
How To Climb Out of the Global Financial Hole
"Now he won't let go of the shovel, and he can't dig out of the hole."
Last week, the market gave a huge vote of no-confidence to the Treasury's plan to rehabilitate the financial system. My impression is that the markets were correctly dismayed at the idea that $350 billion of remaining TARP money would plausibly be "leveraged" into two trillion dollars of troubled asset purchases as if they were loaves and fish, without any need for Congressional approval, much less oversight. Worse, the Treasury's plan is the same bad idea of buying "troubled assets" writ large, with no recognition that the only reason to buy troubled assets is to restructure the underlying debt.
Last April, former Fed official Robert McTeer made a troublesome comment on CNBC in a discussion of the Congressional hearings about Bear Stearns, when the said that now-Treasury Secretary Tim Geithner "answered the questions that he answered very well, and he dodged some questions very beautifully too, and he got away with it." A similarly dodgy tone was evident last Tuesday, but after a year of battering and dashed hopes, the markets were less receptive.
Frankly, Geithner's willingness to rescue badly managed financial institutions with an open checkbook of taxpayer funds, coupled with "Helicopter" Ben Bernanke's willingness to run the printing press, strikes me as an unholy alliance. The pair made their first illegal foray into powers reserved for Congress during the Bear Stearns bailout, when the Fed took on a $30 billion book of risky securities and provided a "non-recourse" loan to J.P. Morgan. This was not monetary policy, but fiscal policy. I continue to believe that the sole function of that transaction was to defend the bondholders of Bear Stearns. The customers and counterparties of Bear Stearns were never at risk - only the bondholders were, and that's who got bailed out.
Consider a typical investment bank with $100 in assets, financed with about $80 in customer liabilities, about $17 in debt to its own bondholders, and about $3 of its own "equity" capital. Once the assets drop in value by just 3% to $97, the "equity" of the firm is wiped out, and it becomes technically insolvent. Bear Stearns died first because it had the highest ratio of assets to equity ("gross leverage") of any major financial company, so it was the most vulnerable to even a small erosion in asset value.
But even after the company's equity is entirely wiped out, the book of assets and customer liabilities in this case is still worth $97 - $80 = $17 to an acquirer in a "pre-packaged" bankruptcy (where all the assets and customer liabilities are sold off as a package, you wipe out the stockholders, and you give the bondholders the proceeds of the sale. The bondholders are only wiped out, in this case, if the assets drop to $80, so the assets and customer liabilities are assumed by an acquirer at zero net cost). Indeed, this is precisely how, just last year, the largest bank failure in history was managed by the FDIC so seamlessly that it was almost forgettable. The stock and bondholders of Washington Mutual lost, of course, but there was not a single penny of loss to customers or the government.
As Joseph Stiglitz, the Nobel economist (and more to the point, one of my former dissertation committee members at Stanford) recently wrote, " It is standard practice to shut down banks failing to meet basic requirements on capital, but we almost certainly have been too gentle in enforcing these requirements. (There has been too little transparency in this and every other aspect of government intervention in the financial system.) To be sure, shareholders and bondholders will lose out, but their gains under the current regime come at the expense of taxpayers. In the good years, they were rewarded for their risk taking. Ownership cannot be a one-sided bet."
I continue to believe that the bullet points for addressing the current financial crisis are these:
Financials that are insolvent and are likely to survive only with large and sustained infusions of taxpayer funds should be allowed to fail in pre-packaged bankruptcies that wipe out both the shareholders and the bondholders of those institutions. Customers and depositors will not be hurt, and it won't cost taxpayers a penny. As Stiglitz notes, "you should not chase good money after bad."
The government should continue to provide capital directly to large, diversified financial institutions which remain solvent but have some impairment to capital. Preferred stock is a reasonable form, though a high (possibly deferred) yield to the government is preferable to a low one (Bagehot's Rule). Tight restrictions against using taxpayer capital for compensation and bonuses are certainly appropriate. These institutions include major banks like Citigroup, Bank of America, Wells Fargo, J.P. Morgan, and others, which appear to be experiencing pressure not because of insolvency, but because of uncertainty about potential future loan losses, and the ongoing availability of publicly provided capital.
Troubled assets should only be purchased if all of the pieces of a given issuance can be collected. The ability to aggregate all of the pieces is necessary because that's the only way the underlying mortgages can be restructured. If, for example, all of the pieces could be purchased at an average of 40 cents on the dollar (which is well above where many of these securities are marked), the underlying mortgages could be reduced by as much as 60%, making them solvent and likely to be repaid. The restructured loans might eventually even be re-sold into the market through the GSEs at no taxpayer expense.
The most direct method of intervening is at the point of foreclosure through the courts. One way of doing this would be to give judges the ability to write down principal, and to assign the balance as a deferred "property appreciation right" (PAR) to the lender. This would reduce foreclosure rates, preserve the value of the existing mortgage securities, and avoid concerns about fairness. A more ambitious government-sponsored program would be to make the PARs an obligation of homeowners to the Treasury administered through the IRS, asserting a claim on the price appreciation of the home or subsequent property owned by the homeowner. The foreclosure court would reduce principal, assign an offsetting PAR obligation to the homeowner, and assign the lender that same share in the Treasury's PAR Fund (basically a national pool of those PAR obligations). The PARs would then be marketable. Though they would undoubtedly sell at a discount to the face amount since not all the PARs will be repaid, they would be backed by a pool of real assets that are likely regain their value in the long-term, if not the near term. The Treasury could aggregate these claims and pay them out proportionately to the lenders, but would not even have to guarantee full payment - just enforce the claims by collecting and paying out.
In any event, the idea of just randomly buying up bad assets from bank balance sheets is an attempt to dig us out of a hole with a useless shovel that will only send us deeper. Unfortunately, we have failed to address mortgage foreclosures altogether. This delay in implementing correct policies will mean large taxpayer expenses, a ravaging decline in the exchange value of the U.S. dollar, long-term (but certainly not near term) inflation pressures, and very little to show for all of it in terms of financial solvency or economic recovery.
I can't emphasize enough how important securitization has been in creating this problem, and how important government coordination will be in reversing it. Suppose a homeowner borrows $400,000 for a mortgage, and you cut that debt up into four pieces of $100,000 each and sell them off into the markets. Suppose we have a pretty good idea that the homeowner cannot service that loan. If capital is tight, the housing market is bad, and the markets are uncertain about the risk of foreclosure and the liquidation value of the home in a forced sale, those pieces may only sell for 30 or 40 cents on the dollar because nobody wants to take the risk.
Worse, none of the holders can restructure the debt, since they don't control the other pieces. Even if the government buys one or two of those pieces, it won't matter. The mortgage will still default because nothing has changed for that homeowner. But suppose the government buys up all the pieces for 50 cents on the dollar, and then restructures the mortgage to something that the homeowner can afford (in this case, the government could cut the principal to $200,000 and still not be out a penny). In that case, the homeowner keeps the house, there is no forced sale to further depress the housing market, and you avoid the add-on effects of unemployment and financial dislocations.
More than anything, we have two problems. First, we have a coordination failure that is preventing the losses already taken on these mortgage securities to be passed on to homeowners in a way that would allow those mortgages to be solvent. Second, we have a procedural constraint that prevents foreclosure judges from restructuring mortgage obligations by substituting principal for property appreciation rights.
Our leaders, particularly those in charge of the financial and monetary policy of the U.S., have not learned anything. Our grandchildren will read in history and economics textbooks what our policy-makers should have done. They will read how the U.S. went on a binge of excessive debt creation in the belief that home prices, stock valuations, and profit margins could do nothing but increase indefinitely. They will read how "securitization" allowed loans to be cut into a million pieces and sold off as soon as they were made, removing all incentive for lenders to make sound loans. They will read how this securitization prevented anybody but the government or the courts from restructuring the debt, because government action was the only way to solve the "coordination failure" and put Humpty Dumpty back together. They will read how our policy makers focused nearly all of their efforts on protecting the bondholders of failing corporations, rather than focusing their efforts on restructuring debt and assisting distressed homeowners. They will read how the lessons of the Great Depression eluded us because we didn't recognize that restructuring debt was the only way we could have avoided a long and difficult economic slump.
Except for the Treasury's almost accidental realization that directly providing capital to the banks was effective, we have observed little but a brute force opening of financial spigots at the expense of American citizens. That is not clear-sighted policy, and it is not helpful. If we don't restructure debt, we may as well do nothing. We are throwing good money after bad, and running printing presses at full steam. I wish I could be more optimistic about this situation, but I take a good amount of information from market action, and it is clear that the market's confidence is wearing thin.
Credit default spreads continue to hover near their highs, and financial stocks continue to press near their lows. The pending loss of investor confidence here is palpable, and we have to recognize that if the November lows do not hold well, Pandora's Box will swing wide open. President Obama has an important opportunity on Wednesday to propose something along the lines described above. The remaining confidence of the markets is fragile, and "revulsion" could set in quickly if policy-makers don't reverse the Treasury's lack of credibility.
We are somewhat slower to accept fresh market risk presently, compared with late last year, because the markets have consolidated the prior losses, prices are no longer as severely compressed, the "ebb and flow" of economic data has been decidedly unfavorable, and policy responses have been poorly targeted. Unfortunately, the longer this recession wears on, the longer we will observe high risk premiums, which translates into lower average P/E multiples in the years ahead, compared with what we've observed over the past 15 years. Bill Hester has an excellent research piece this week on the relationship between valuations and economic trouble: Stock Market Valuation Following The Great Moderation (additional link at the bottom of this comment).
I do expect to to modestly increase our exposure to market risk on significant price weakness, as stocks do appear priced to deliver reasonable long-term returns (even if not necessarily shorter-term progress). Still, I am mindful that further market losses may not be contained to a simple "retest" of prior lows.
As of last week, the Market Climate for stocks was characterized by favorable valuations and unfavorable market action. The modest early improvement in market internals we saw a week ago is quickly failing though not entirely absent. That provides a slight consolation here, but the overall evidence is not very supportive of risk taking. The Strategic Growth Fund remains largely hedged against market fluctuations, with a fraction of 1% of assets in call options essentially as a small concession to the remaining "early improvements" in market action (which cling by their fingernails to the precipice). Suffice it to say that the primary driver of our returns here is not overall market movement, but the difference in performance between the diversified portfolio of stocks held by the Fund, and the indices we use to hedge (primarily the S&P 500, Russell 2000 and Nasdaq 100).
In bonds, the Market Climate last week was characterized by moderately unfavorable yield levels and relatively neutral yield pressures. With the recent resurgence in credit spreads and the spike in Treasury yields, the further downside pressure on Treasury bond prices has eased. There is certainly some long-term risk of inflation inherent in the Fed's willingness to more than double its balance sheet in recent months (and will get worse if the Fed monetizes the Treasury's debt by buying Treasury bonds and paying for them by creating money). However, the short-term risk of inflation continues to be insignificant, as the continued flight to safety has created a great deal of demand for government liabilities. The greater near-term risk is that of a fresh plunge in the U.S. dollar, which appears increasingly likely.
In the Strategic Total Return Fund, we remain significantly invested in Treasury Inflation Protected Securities, which provide reasonable absolute yields relative to straight Treasuries, since the long-term inflation assumptions in those securities is still minimal. The Fund also holds about 15% of assets in foreign currencies (following some additions on foreign currency weakness last week), about 10% of assets in precious metals shares, and about 5% of assets in utility shares.
New From Bill Hester: Stock Market Valuation Following The Great Moderation
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