naked capitalism

Scott Finch says:

“Default is likely to be accompanied by a currency crash and a spurt of inflation.”

There was an interesting paper that was published at nber.org about two months ago. The title of the paper was something like ‘the forgotton history of domestic debt’. The paper included various time series sets over different metrics.

Richard Kline says:

The gubmint is going to intervene in the GSEs on a ‘failure is not an option’ basis. And rightly so. Why? Two reasons, both inescapable.

First, GSE paper has been pushed by the Fed and the Treasury on a ‘good as Treasuries’ basis to foreign sovereign financial institutions and CBs.’ Our public authorities _must_ make good on this debt, or we will of a certainty see the complete collapse of our currency. That is the worst of all possible options, solving nothing while ruining everything; let’s not go there. Second, the mortgage market will continue to exist throught he next three-five years if and only if we have a market maker for conforming loans at least. If we let these institutions fail, we will have to charter another, but in a vastly worse capital environment where any belief in the viability of the market-maker model has been shattered.

The question then is how to go about it, and what’s the best bang for the buck? While in general I favor nationalization, at least for banks, I’m less keen on it here. The liabilities for the GSEs far exceed those for the banking system, and as mentioned above will be harder to walk away from due to the structural consequences of doing so. Here, I think that Kaufman’s proposal is actually the best one I have seen, at least as a starting point. I don’t say this to favor existing equity holders in the GSEs, but they have very nearly been wiped out already if they are still long. Putting in equity keeps the GSEs intact, keeps them able to borrow on the capital markets to do business, and staves off a default cascade from their paper going sour en masse all at once. An equity stake can be sold off years or decades hence, potentially netting back something to the public till. The GSE staff are going to have to do extensive cramdowns on their wholly owned paper; it will be cheaper to keep them and let them do it, salvaging what they can on the loans’ underlying value. That’s a better outcome than junking these concerns and starting over.

But here’s a twist I haven’t heard. Yes, the GSE’s should cover what they hold in mortgage bonds, with public equity providing the cushion. But their ‘guarantees’ on what they have put out there should be spilt off by Congress into a sepearate vehicle, with the explict understanding that the government will write down these guarantees as it sees fit, and that only after the mortgage holders do work-outs directly with the homeowners. The public simply should NOT stand behind guarantees made against bubble prices, at least at par. If necessary, the ~$70B of the GSEs present assets could be dedicated to this spinoff while the government keeps the remaining GSEs afloat and the guarantee buyers take what slice of the pie in the runoff spinoff. There will be much screaming about this, and the mortgages with trimmed guarantees will of course plunge in value—but less than if the GSEs simply default. The real exposure to vast loss in the GSEs in in these guarantees; the institutions can be salvaged absent that exposure.

Going forward, the entire idea of ‘guaranteed values’ for mortgages needs to be sharply reconsidered. It might be appropriate for an issuer to guarantee to take a first loss position to a set level in the event of a decline in value of a mortgage, but that position should not be open ended. Buyers of mortgages need to see and assume more direct risk for price movements in the future, and this will need to be priced into the morgages themselves: it is the illusion of a _guarantee_ against loss which has helped to promote reckless _acquisition_ of mortgages by speculators.

Will the present Congress do anything of the sort? Not a chance. The ‘housing bill’ and the ’stimulus check’ boondogles we have seen to this point clearly state that most in Congress neither recognize their lack of competence in the issues, act at arms length from the Big Money constitutencies who put them in office, nor have any functioning organs lower than their pectorals. The Congress does have the encompassing legal authority to pass emergency intitiative legislation, and the staff competence to propose a comprehensive regulatory reform. The latter will take several election cycles, but that’s the norm. The former is desperately needed by the end of the year, really by October, but we just aren’t going to get it. The Democrats have no nerve, the Republicans have no shame, and together they are like matter and anti-matter, unable to produce a substantive reaction. And look, we elected these losers so We the People Need to look in the mirror and call out the mooks looking back at us there.

. . . But yes, an equity intervention seems the best, thin end of the wedge for this gem-knapping operation, so let’s get on with it. By Monday, Hank and Bennie, by 0700 EST.