I wrote last week about how to "Keep a Clear Mind in 2008." This past Monday I read Paul Krugman's NYT column titled "Innovating Our Way to Financial Crisis" and realized that there are some very widely read people like Mr. Krugman and Bill Gross who seem to be dedicated to agendas rather than merely explaining things in an objective manner.
Krugman describes the mortgage mess and the consequences thereof in these words "This time, market players seem truly horrified — because they’ve suddenly realized that they don’t understand the complex financial system they created" and "But what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried."
I think that both of those sentences are essentially incorrect. Granted that individual participants in a market such as mortgages may not have a comprehensive understanding of the entire process. So what? I don't care that the guy who designed the engine in my car does not know how to design an automatic transmission. Implication that somehow the mortgage origination, securitization and derivative parts of the machine formulated incomplete models based on lack of understanding is entirely false. The totality of the problem is that inane mortgages were made with greed as the sole purpose. Everyone already knew how to make good mortgages and how to construct good MBS and credit derivatives they simply cast the models aside for short-term gain.
The heart of the problem is incredibly simple and I have been writing about this for months. Absurd lending standards were adopted and packages of ridiculous loans (with stated income, B-paper, 100% CLTVs leading the charge) were created and sold to suckers. When the folks who could never afford the payments stopped making them the suckers stopped buying the story and the mortgages.
As for "But what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried" that is also incorrect. Everyone holding this "toxic waste" knows darn well how much of it they have. What we have at present is a poker game situation. The folks who hold mortgaged backed securities and mortgages intended to become mortgage backed securities want to maximize the price that they sell at and full disclosure of their exact positions is incompatible with maximizing profit (or in this case, minimizing losses).
Krugman then sidestreams into the "housing bubble" with this: "In a direct sense, this collapse of trust has been caused by the bursting of the housing bubble. The runup of home prices made even less sense than the dot-com bubble." There are two glaring errors there. There is a big difference between these "bubbles." Folks actually need housing. No one needed dot-com stocks. Yes, speculation is condos which people never intended to occupy inflated prices but that is not and has never been the heart of the housing market. Also, Krugman has his cause and effect wrong. Housing prices are being negatively impacted by the mortgage markets incipient return to sanity. The lack of trust in funky mortgages is deflating values not the other way around.
Krugman does a wonderful service in this piece by bringing up the opinions of Bill Gross. Bill Gross manages PIMCO. PIMCO is the world's largest bond fund and Bill Gross runs it. PIMCO has something on the order of $680 billion is assets. Here is Gross's statement as quoted by Krugman, “What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.”
Let me stop myself for a second. Who the heck am I to be criticizing Bill Gross? Seems foolish on the surface. I mean he should know 1,000 times more than me about these topics. Well maybe he does but there is an underlying problem that I have. Media should not freely quote Bill Gross because he has a large stake - no, not a large but a gigantic stake - in the market. It is in his interest to not have everyone as well informed as he is. In short, it makes no sense to listen to him because objectivity does not serve his interest. People should not get market advice from folks with a large stake in the market. Advice should be coming from neutral parties and Bill Gross is the opposite of neutral - he is highly vested.
That notion aside, go back and read what he says about Bernanke "a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August" the read Bernanke's speech in May 2006 about Hedge Funds and counterparty risk. I suppose that Mafia dons could give the head of the FBI a refresher course in hijacking cigarettes.
The point is that despite Gross's words our modern banking system is not breaking down. Is it being stress tested? Certainly. Breaking down? No. It is not breaking down for several reasons: 1) the large commercial banks have the capital to take these losses. Yes, decreased net worth will lower their ability to lend for a few years but this is happening just when the demand for mortgage debt is decreasing 2) housing is not a true "bubble" item because unlike useless dot-com stocks people actually live in houses and 3) the very fact that here in the good old USA we love to tear all of the wrapping off and look inside problems such as this serves us well. The problem is addressed and dealt with quickly. This may not be pretty but it serve well to identify problems and formulate remedies.
In his recent piece on his concerns over the risks associated with relatively unregulated hedge funds Gross make some excellent points in referring to them as a sort of "shadow banking" system. But it is not the case that any shadow banking system created the current mortgage mess. The greed and stupidity of people who knew perfectly well what good mortgages looked like but abandoned those standards for short-term profits was the heart of this mess.
Gross did write an interesting piece in September suggesting that fiscal policy (some sort of bailout) not monetary policy (lower Fed funds) was necessary to resolve the mortgage mess. This past week focus has shifted toward a negotiated freeze on subprime mortgages about to adjust. Assuming that whatever ensues here has a Safe Harbor to address the fact that the people who actually own the cash flows from these mortgage are going to be shorted then it may prove to be the case that this is really a delayed and somewhat disguised bailout. Personally, after I read what I could on the "teaser freezer deal" I see no way in which it can work. The cash flows are not owned by the parties to the deal (the Feds and the servicers). If this were 20 years ago I could have inserted a comment such as, "What is this? Russia?" but you get the idea.
Krugman's laments about the effects of innovation things such as CDOs and SIVs in not well founded. Crappy mortgages are the problem. Yes SIVs and CDOs helped obfuscate the effect of making those crappy mortgage but the truly silly thing is that all we have to do is to stop making the inane mortgage products which our industry has created in the past five years. Actually the problem is largely already solved. These products simply are not being made. We just need to clean up the litter made over the past few years.
- Dick Lepre
