Crisis Note 2009-1: Excess Assets, Keynes, etc.


Its been a while since I wrote the last Crisis Note (although I've started many) - since then, much has happened in the markets, mostly in hopeful response to various pronouncements by the incoming administration. However, the fundamentals have not changed, and it is my opinion that much of what has been proposed will make matters worse, not better!

In this Crisis Note, I will discuss various concepts and scenarios I've been thinking about for the past few months. As always, I will note that these opinions are mine, and not those of any of my employers.

1) Bonds are not assets

The most important concept that our economists, regulators and politicians don't seem to understand: bonds are not assets - they are contingent claims on assets. It is only when the equity behind the bonds is wiped out that bondholders become the owners of the underlying assets. Prices for bonds thus tend to follow the prices of the underlying asset, due to the connection with the cashflows generated by the asset, but they are never an asset in the economic sense of the word - a means to generate "rent". This is true of most "financial assets". They are assets only in the accounting meaning of the word, but are not fundamental means of production. The press shares blame in this too - their harping about "toxic assets" when discussing bank portfolios is misguided too.

I prefer to use the term excess assets instead of toxic assets. Excess assets imply assets that have no economic use at present, as there are sufficient other assets in the economy that can meet the demands of consumers. It is possible that they might have an economic use in the future (say once the population grows, etc), but for the present are doomed to declines in their value, unless an alternative economic use is identified for them.

The current crisis has arisen as there are excess assets in the global economy - built due to the availability of excessive and cheap credit. Houses, office buildings, cars, planes, hotels, factories, etc - that these have been built, there is no doubt. And many of these have been funded through securitization - of that there is no doubt too.

Securitized credit flows through a one way valve. When credit is available, assets get built, especially if there are other considerations - bull markets that never appear to end, low risk premiums, pressure on CEOs from equity analysts to maximise ROE, etc.

However, taking securities off financial balance sheets (that are accounted for as assets) and hiding them in acronyms that start with T or P, cannot make the underlying excess assets disappear. You cannot play the securitization film in reverse!!! The various underlying excess assets are still out there, and as long as they are non-economical, their prices will continue to decline. And with them, the prices of the bonds that are collateralized by them. 

Bonds are like a mirror. The bonds will always reflect the value of the underlying assets. Throwing a towel over the mirror will not change the price of the underlying assets.

The government's plans to buy bonds cannot and will not have any impact on the ability of the economy to absorb these excess assets and find an economic use for them, and thus cannot stabilize their values. This includes the latest plan to create an "aggregator bank" to hold "toxic assets".

2) Lowering Mortgage Rates

The government has made the decision that a 4.5% mortgage rate will cure all ills, and allow home prices to appreciate once again. By directly purchasing billions of Agency MBS from the market, they hope to drive mortgage rates down. They will succeed in lowering mortgage rates. But in my opinion, it is unlikely to have an significant impact on home prices.

Micro Economics anyone? Prices of assets are determined by the demand for and suppply of assets. If you can increase demand, while holding supply constant, prices will go up. If you can decrease supply, prices will go up. Increasing credit availability, and reducing the price of credit can only help to increase prices if you hold supply constant, or reduce supply.

As discussed above, there has been no serious attempt to reduce suppply in housing. Thus housing is in a downward spiral - unemployment and unqualified homeowners (that bought homes that were too big for their incomes), continue adding to the supply of houses for sale. In addition, by simultaneously providing tax breaks to home builders (in the name of maintaining employment in the home building sector), you are allowing them to offload their portfolios of unsold homes via subsidies, thus further increasing housing supply.

In any case, it is questionable how many more homes can be sold or resold by lowering the cost of mortgages. It is hard to imagine that the demand for home ownership has not been fully met over the past few years, when even down payments were not required. The only remaining potential new homeowners might be new immigrants, or new entrants to the employment markets (college grads and other young adults leaving their parents homes). These marginal consumers of home ownership are likely to face more stringent underwriting standards than in the past, and my opinion is that only a small percentage of them will qualify for a mortgage.

One can argue that the reason for lowering mortgage rates is to get the universe of current mortgage borrowers a lower monthly payment, in order to put more disposable income in their bank accounts, which might reduce foreclosures, and also stimulate the economy if the savings of a lower mortgage payment are spent on consumption instead of being saved. Again the key question is: with home prices having declined about 25% or more so far, how many borrowers will be able to qualify for a refinancing without putting up more money? Unless underwriting standards are abandoned, or LTV requirements are ignored, it is my opinion that many borrowers are unlikely to be able to refinance their existing mortgage balances. We are likely to see a short burst of refinancing activity, as those capable of re-qualifying for a new mortgage (exactly the people that don't need help) go ahead and refinance, while the rest of the existing borrowers discover that they cannot refinance without putting more equity into their homes. Could the refinance application process lead to an unintended consequence - an increase in in jingle mail and foreclosures, as people are confronted with how little equity they have left in their homes?

The unintended consequences are much greater. At present, the market is already discussing the risk of crowding out of longer Treasuries. With stock markets declining, where will our pension plans invest? MBS has traditionally been a way for pension plans and insurance companies to earn yield. How will they now achieve their required return to meet their future pension obligations when MBS yield 4.5%? This lowering of yields is likely to make pension plans even more underfunded in the future. And, if the government ever tries to sell their half-trillion MBS portfolio in the future, agency MBS prices will decline, further increasing the pain for pension plans, especially if they followed Bill Gross' recommendation to invest along with the government.

3) Keynes and Infrastructure Spending

One of the most annoyingly overused quotes over the past two months was Nixon's "We are all Keynesians now". This has been used to justify the quantitative easing and infrastructure spending programs we have embarked upon.

What is incredible to me it that very few people in power have studied the 2 times Keynesian policies were used in the recent past: the Great Depressian, and Japan in the 1990s and early 2000s. Bernanke is purpoted to be a Depression expert, and the only American I've found that might be a Japan expert is Paul Krugman, our latest Nobel Laureate.

(Here's a link to his Japan page. Krugman is described as a New Keynesian by Wikipedia.

Lets talk about the Keynesian implementation during the Great Depression first. Keynes great contribution to macroeconomics was the concept of aggregate demand - national product or GDP is the aggregation of the demand for all the goods and services created in the economy, and he divided it into consumption demand from households, demand for investment, as well as government spending, plus the net demand from foreigners. 

Keynes proposed that when an economy fell into recession due to a decline in aggregate demand, government spending could make up for consumption demand from households to keep the economy chugging along and employment high. Thus he proposed massive government spending during the Great Depression - pay people "to dig holes in the ground", to keep people employed. (What is not often mentioned is that Keynes discussed paying for such holes out of savings, something we currently appear to have a shortage of.)

As an aside, lets see how one could pay for all this hole digging: a) out of savings b) from taxes c) funding via bonds or d) printing money.

a) If paid for out of savings, it will increase aggregate demand, especially when banks are bankrupt as they are now, and there is no multiplier effect in the economy from money saved in bank accounts. But this will not have a multiplier effect either, and such spending is limited to the size of the savings.
b) If paid for by taxation, there will be no net effect - increases in taxes will reduce funds available for consumption from those being taxed.
c) If paid for by bond issuance, one could use the savings as the credit enhancement for the bond issuance, thus creating a multiplier effect on the spending over a).
d) If paid for by printing money. this could devalue savings, and the currency, and increase inflation in the future.

Coming back to the Great Depression. There are 2 schools of thought as to whether Keynesian policies worked during the 30s - one school believes that it did, while the other believes that it did not! One thing is clear - no one really knows, and it is not clear that we are done paying for it either, as we have huge Social Security and Medicare liabilities due as the Baby boomers retire. In fact, it has been argued that this has reduced the purchasing power of the US currency, and brought us to a point where we will be unable to pay off our debts.

Summarizing the effects of the New Deal: the government spending created jobs during the 1933 to 1936 period, (resulting in the stock market going up), but most of it was non productive and at best artificial (eg increasing farmers income by reducing the output of food by killing pigs and burning crops). When Roosevelt thought the worst had passed in 1936, he began cutting the spending and refief programs, and the US slipped back into another recession. Were it not for the timely intervention of WWII, and the fact that we won it, I suspect we'd still be in a recession, if not a depression.

Moving onto Japan in the 1990s and 2000s. I find this a much more relevant comparision to the position the US finds itself in, and I view this as critical to understanding the problem. I will go into depth in a different section. The NY Times recently had a terrific article describing the amount of money Japan wasted in Keynesian stimulus, and it is worth reading:

The most quote worthy phrase is on page 3: “Roads and bridges are attractive, but they create jobs only during construction.” Obama's policy makers should heed this and beware of Keynesian spending.

I believe that stimulus spending by the government has rarely worked in the past, and in general is unlikely to do so. The only time the government should get involved with capital spending is when the risk or the size of the spending is too high for private investors to finance, or it serves some social need that the private sector won't finance. In general, this should be very rarely. Otherwise, we will get stuck with inefficient uses of our savings and capital, which in turn will lead to a national decline in productivity. 

A good example was the Space program in the 60s. It led to the creation of new science. Without government funding, this would not have been possible. Our current energy delivery mechanism is a good counter example - in spite of volatile energy prices, remote locations, hardships of extraction, global energy extraction and delivery has mostly been privately financed. Most governmental interference in this sector has been theft more than anything else.

In the current legal environment in the US, maybe nuclear power plants should be financed or assisted by the government- mainly due to the costs of litigation insurance in the US. Walls, fences, bridges, roads, museums, and football stadiums rarely qualify.

Barron's had an excellent article on infrastructure spending in the past. I have been misquoting it in conversations intentionally!

I agree with them that for infrastructure spending to have any impact as a stimulus, it should increase productivity. A good example of successful spending was the lighthouse at Alexandria - it made shipping safer and led to increased commerce. I've been saying that it is possibly the last successful infrastructure project undertaken by a government. It can be argued that the Pyramids succeeded too - they increased tourism in Egypt - but it took them 5000 years, and maybe they didn't really succeed - it was the Yen Carry trade that created the wealth for tourism to become a viable economic activity!

Samir Shah, 01/21/2009