Most of the time, the path to survival in financial bureaucracies is through company-party-line on-message bullishness. That’s particularly true in the US, where pessimism about the future is not just bad business, but unpatriotic.
Not true today. More than sufficient electric shocks have been administered to the rats. Now, the corporate rodents know that PowerPoints projecting trees growing to the sky are going to get you fired, not promoted. Short-sellers are no longer bad people, but prophets. That’s part of the reason why the optimistic case for equities is still generally dismissed.
There are, however, substantive points made by the equity bears. The most coherent come from the credit people, who point out, grimly, that you can’t have a recovery if you don’t have the bank lines or fixed income buy side to support the spending. The damage done from write-offs and shaken confidence is so severe, they say, that it will be impossible to finance growth in any kind of demand, at least in the visible future. No bank capital, and no securitisation markets, mean we will all be reduced to post-apocalyptic bands of looters, hunter-gatherers, and, I suppose, bankruptcy lawyers.
Since the more cautious credit people saved their clients some of their capital, they deserve a listen. Greg Peters, the Morgan Stanley credit strategist, says: “Once the banks and credit institutions pull back their reins, they keep them pulled back for a long time. The more optimistic consumer economists don’t understand this because this is very different compared to any other experience they have gone through. It is impossible to calculate the impact of the breakdown of securitisation.”
That’s true. Of course, we did have some economic activity even before the securitisation of subprime and alt-A mortgages, and before collateralised loan obligations replaced actual corporate loans. We survived on iceberg lettuce and coleslaw before we knew there were such things as arugula and cilantro.
Still, to the point raised by Peters and the other cautionary voices, there are answers. First, Fannie Mae and Freddie Mac need to be nationalised, in the sense that the federal government injects capital in the form of preferred equity and direct credit support, wiping out the existing common. I believe it is critical that that takeover leaves the privately held preferred stock of the government-sponsored enterprises in place. Preserving the value of GSE preferred issues is very much in the taxpayers’ interest, as it makes possible the recapitalisation of the rest of the banking system.
Most of the discussion of the need for a federal takeover of the GSEs has concerned their credit losses on subprime and Alt-A paper. However, even if a private recapitalisation could be done to offset those, the GSEs would not have sufficient capital to handle the long-term risk of the maturity mismatches on their highly leveraged balance sheet.
Let’s say there’s a great economic recovery, housing prices stabilise, and the interest rate curve becomes more normal. The rise in long-term rates would lead to an extension of the maturity of mortgage portfolios, which would need to be offset by hedging activities. Significant declines in the long end would also need to be hedged, as homeowners refinanced. I don’t believe the interest rate swaps market will have the capacity or willingness to take on that risk at any payable price. One way or another, these institutions will spend a considerable time with negative equity. Again. The only way to handle that is with government ownership.
No doubt there are bankers and lawyers explaining all this to the Washington “leadership”, in the respectful, but urgent, tones trust and estate lawyers use when telling dim heirs that they need to sign a document lest Mummy’s bequest become valueless. It could take a little while for the political managers to accept that they need to shred yet another set of talking points.
Then, all of those fiduciaries worried about making that 8 per cent return assumed in their actuarial pro formas will have a way to keep their jobs: buy new issues of bank cumulative preferred stock.
How could they have confidence in the banks? Because the banks will be able to put a lot of their housing paper to those newly recapped GSEs. On the other hand, they may want to hold on to at least some of that paper. There are a lot of housing-related securities that will take real losses on foreclosures and steeply discounted liquidation sales. There is also a lot of paper that was marked to a very illliquid market. Away from Florida, Nevada, Arizona, parts of the Rust Belt, and California, there is a lot of solidly financed property in the US, and a significant part of the paper it supports will be marked up in value. That will be another source of additions to bank capital.
We won’t be getting another consumption-led boom for a long time. The US will recover, though, and sooner than the credit tribe thinks. There will be exports, import substitution from transplanted factories, cheaper oil and government-financed infrastructure spending. Capital flight from Europe will help finance the construction of our next perpetual motion machine.
When everyone regains their confidence, I’ll get bearish again.
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