Tuesday, March 11, 2008

Trying to fix the symptoms rather than the causes?

An extra $200 billion liquidity injection by the Fed is providing the market a positive boost today, but I’m not convinced that this effort is different from previous efforts in anything other than scale.

The problem has been growing since last summer’s sub-prime implosion, as credit market after credit market becomes infected by institutions that are unwilling to trade and markets “seize-up”. With each new credit market there appears to be a new twist. At first the problem was only sub-prime debt, but then people became worried about debt tied to prime (i.e. normal) mortgages as the housing slump deepened. Part of the problem is that lending practices became downright shoddy once banks earned a fee for making every loan and another fee from selling the debt on to third parties. In the past the bank held the loan and would suffer if the loan was not repaid in full—not so in this brave new world.

Another part of the problem is that the rating agencies which provided overly optimistic credit ratings on sub-prime debt also appear to have applied the similarly optimistic ratings to regular mortgage debt, and credit card debt and just about every kind of debt they could rate. As a result nobody can trust the credit ratings. Also in this time frame the “models” banks use to value derivative debt instruments (credit swaps, slices of credit pools, default insurance etc) “blew-up” as markets experienced multiple events in a matter of days the models predicted were once in a lifetime events (a.k.a. black swans—highly unlikely occurrences). I think it was about this time the SIVs (structured investment vehicles: off the books enron-like entities banks set up to take the pieces of debt nobody else would buy) disintegrated, forcing many banks to take the loans back onto their books.

So first the growing rate of defaults causes people to question the credit ratings, then the models banks use to value debts go flat. Now banks have a whole mess of dodgy loans tossed back in their laps, and nobody has any idea what, if anything, they are worth. So then banks cut back on lending, begin raising new capital and start writing the bad debt down. This is fairly standard bank behavior which tends to drain liquidity from the market when banks slow/stop lending. Now as the banks write down the debt, the institutions that use (sell) their own strong credit rating to guarantee other debt issuers (they in effect co-sign the loans so the borrower gets a better rate) start to recieve a flood of claims which calls their own high credit rating into question.

And this is about where we are, people (banks included) are afraid to trade debt because, 1) they don’t trust the rating agencies, 2) they don’t trust their own models for debt valuation, 3) the institutions with the highest credit ratings whose job it was to stand behind other peoples debt don’t look terribly sound, 4) there is a bunch of toxic (worthless) debt swirling around. Imagine trying to drive around Baghdad with only a map of Kirkuk in the car, a faulty fuel gage, and the local giving you directions is obviously lost but the one thing you know is that there are IEDs along the road…

But I digress…through all this the Fed has been furiously cutting interest rates to try to boost the liquidity that the banks are draining away as they try to clean up their books. In other words the Fed has been treating the credit crisis as a cost of credit crisis.

Perhaps the terminology is confusing…let’s say you are going to an art auction (you know nothing about art) and a famous painting comes up for sale, but it is selling for only 50% what it should be selling for. On one side of you the person says it’s a worthless fake and on the other side is a guy willing to lend you $500,000 to buy the painting for 0.5% less interest than your bank charges. Do you bite? Most people would be more worried about paying $500,000 for a fake than the good interest rate. And this to me is exactly the problem with the Fed’s efforts; they are trying to fix the symptoms not the underlying problem.


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