Mohamed El-Erian Argues for Propping Up Asset Prices

Mohamed El-Erian, former head of Harvard Management Company, now co-head of the biggest bond investment firm, Pimco, has been a reliable source of insight into the operations of financial markets and the implications of policy measures.

Well, at least until today. In a comment in the Financial Times that shows him to be wearing an investor’s hat, El-Erian argues that the powers that be need to do more to slow the deleveraging of the economy, and that waiting for fiscal measures to salvage housing will take too long. The Fed needs to buy mortgages outright and foreign central banks need to intervene to prevent the disorderly decline of the dollar.

I hate to say it, but why do so few people want to confront the fundamental problem?. The housing market is too big for the US government to keep prices at an artificial level. And to what avail? To saddle new buyers with overvalued property? Home prices are falling because they got to be vastly out of line with incomes and rentals. You cannot maintain an asset prices at levels that cannot be supported by the underlying cash flows.

Estimates of mortgage market size vary, The MBS market is reported to be $6.1 trillion. The total mortgage market may be as large as $11 trillion. The Fed simply can’t buy enough paper to have any meaningful impact. Paul Krugman pointed this problem out earlier:

And the usual problem with such intervention applies: the financial markets are so huge that even big interventions tend to look like a drop in the bucket. If foreign exchange intervention works, it’s usually because of the “slap in the face” effect: the markets are getting hysterical, and intervention gives them a chance to come to their senses.

And the problem now becomes obvious. This is now the third time Ben & co. have tried slapping the market in the face — and panic keeps coming back. So maybe the markets aren’t hysterical — maybe they’re just facing reality. And in that case the markets don’t need a slap in the face, they need more fundamental treatment — and maybe triage.

What is surprising is that El-Erian should know better. But has he stooped to talking his own book?

Michael Shedlock back in August looked at the composition of Pimco’s flagship “Total Return Fund” and found it to be overweight Fannie Mae and badly overweight mortgage paper generally. I don’t have access to Morningstar, otherwise I’d chedk to see if this was still true.

It makes far more sense to try to attack the damage suffered by individuals and families in the housing crunch that to throw money at the hopeless task of propping up real estate prices. The very knowledge that the market has not found its true value will deter both private lenders and homebuyers from re-entering.

Having said all that, there is one feature that redeems El-Erian’s article somewhat. He compares our situation to that of a third world country. The more we face up to unpleasant truths, the more likely we are to come up with realistic solutions.

From the Financial Times:

It is déjà vu for those who remember previous emerging market crises: imploding balance sheets, a bank run, disorderly falls in the currency and emergency policy responses (including on a Sunday evening). Yet there is a huge difference: this is happening in the US and not in an emerging economy.

In spite of significant – and previously unthinkable – measures, the US still faces the risk of further reductions in financial leverage in both the economy as a whole and at the level of individual companies. Sudden stops in the availability of liquidity remain possible, especially for hedge funds; and “price gapping” – where asset prices rise or fall suddenly – will remain the norm. As they consider what to do next, the US authorities would be well advised to study the experience of emerging economies. If they do, they will focus on three main findings.

First, incremental steps using traditional policy instruments are inef fective. As Sunday’s announcements from Washington indicate – including the creation of a lending facility for primary dealers – crisis management is about imaginative policies in the context of high uncertainty. Second, it is no longer a matter of designing a perfect policy response. It is about finding the one with the least collateral damage and backing it with meaningful international support. Third, the earlier the authorities move with their policy response and stay ahead of the process of reducing levels of leverage, the less severe will be the clean-up that needs to be done once the financial crisis abates.

Where do US policymakers stand relative to these findings; and what are the implications? Over the past few weeks, the policy stance has evolved away from reliance on traditional instruments. Part of this – such as the Federal Reserve’s bold attempt on Friday to contain the sjtuation at Bear Stearns, the investment bank, and Sunday’s follow-up announcements – is the result of forced events. Part is more deliberative, reflecting the need to target housing, which lies at the centre of the turmoil.

There is now recognition that the incremental approach did not succeed in getting ahead of the reductions in leverage. Instead, markets looked for a floor for asset prices using a disrupted mechanism of price discovery in the context of illiquidity. To stop this from pulling the rug from underneath the domestic economy, policymakers now face the unpleasant reality of having to cross at least one of two lines in the sand: altering contracts so that stressed mortgage holders can avoid default and foreclosures; and/or explicitly using the government’s balance sheet to support the housing market. The aim must be both to complement Fed financing and to shift the policy focus from institutions to assets.

Breaching either line involves long-term damage to the US economy – most notably through moral hazard. In intervening to stabilise the system as a whole, the authorities end up protecting certain people and institutions from the consequences of their ill-advised actions, thereby undermining the discipline that is crucial to market efficiency. As unpleasant as this is, the moral hazard risk is inevitable at this advanced stage of the crisis. Indeed, the question is not just what happens to irresponsible lenders and imprudent borrowers. It is also about the damage that is being inflicted on others as the financial system freezes.

There are other components of collateral damage. Crossing the first line critically undermines the sanctity of contracts and, at the very minimum, leads to a persistent increase in the risk premiums that lenders impose on all borrowers. In addition, there may be unintended consequences that erode the integrity of the market system.

The other line, which involves the authorities’ balance sheet, amplifies inflationary pressures and weakens public finances. Yet these costs are less persistent and, as such, lower than those associated with the alternatives. Indeed, the real cost of the second regime shift is more nuanced. It relates to forcing institutions to operate outside their comfort zones and, perhaps, beyond their core competencies.

This is what the Fed faces today. Its traditional instruments are too blunt to get to the root of the problem. They must be supported by fiscal measures that target housing directly. Yet there are inevitable operational problems in using the Federal Housing Administration, creating a new institution or approving a new fiscal package. As such, a Fed that is anchored by a dual (growth and inflation) mandate may be forced to go beyond financing institutions and engage in fiscal action through the use of its balance sheet.

How about the international dimension? The past few weeks have been characterised by a deafening silence on the part of the European and Japanese policymakers when it comes to the US situation. This has contributed to currency market instability.

All this suggests that are no easy answers for policymakers; but there is a right answer that consists of at least two additional components.

First, supplement monetary policy by getting the Fed to fill the void left by slowing moving fiscal agencies – through outright purchases of high-quality mortgage securities or by extending financing terms to one year. And, second, there should be co-ordinated central bank intervention to counter disorderly exchange rates that exacerbate the credit turmoil.

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  1. Anonymous

    There is a world of investors waiting to purchase “AAA” performing bonds. We, however, are caught in a crazy loop where everything is junk. Repackaging junk does not change it into roses. Lieing about the quality in an attempt to unload the shit on unsuspecting investors creates the insolvency crisis we have today.

    The Bush administration is fundamentally incapable of coming up with an honest solution. I suspect that the effort to privatize social security was to bail out CDOs and that was why Hank Paulson surfaced. The bail out proposals are as suspect as the underlying.

    The cardinal element is the cost of home ownership, which is far below the CDO price. The only way to prop up home prices for the term of the loan is to provide low cost, assumable mortgages. Otherwise, the prices must fall. And fall they are.

    I personally do not want to see wall street survive in its present form. Why can’t we force liquidation of wall street to foreign banks who are willing to underwrite the garbage and turn it into roses. Off-shore the offshorers.

  2. Anonymous

    Everyone admits these are interesting and unprecedented times. Yet the same fools who didn’t predict this situation are more than willing to puff up and tell us what needs to be done.

    I have a modest suggestion. Let’s do nothing and see what happens. Unlike the protagonist in Poe’s “Descent into the Maelstrom,” no one is in a position to understand the forces at work sufficiently to take stabilizing countermeasures. Bernanke’s “shoot from the hip” approach will most likely have unintended adverse consequences.

    What I don’t find is collective intelligence but rather just a bunch of squawking and self-serving commentators (not referring to you here, Yves) talking up their own book.

    We are confronting systemic problems in the global financial system yet no one has the authority or grasp of the situation required to promote stability. Or so it seems to this gopher.

    The same clueless crew that navigated us into this storm is still in charge. They blunder about and perhaps they will shoot themselves before they kill us. That may be our best hope.

    All this because of the invention of the plow. Blame agriculture.

  3. Anonymous

    pimco owns mucho amounts of freddie and fanny listed under ‘government’ even thou it isnt really a gov agency….pimco need freddie and fannie backstopped by law or they are toast when both collapse…….

  4. S

    The irony is too rich to listen to Pimco shills tell us how it is ok for the broker dealers and fed to park collateral becasue after all theses securities are “money good.” This as he mutters how the governement should be buying mortgages that arn’t technicially in distress because they are not money good. Mr. Pimco,

    How exactly does buying mortgages do anything for joe citizen who can’t affrod it?

    How exactly does this encourage banks to originate the low rate mortgages that fueled those strataspheric prices?

    How do investment banks rewind and brainwash the public and financial complex into buying this securitized garbage?

    Finally, are you a firm bid if we can get the gears cranking again?

    The solutions are always worse than the problem. maybe it was his time at Harvard.

  5. rexl

    anon 11:34, I totally agree with you. And I don’t believe any one is learning when the consequences of mistakes and bad decisions are muted by the mother fed coming to the rescue. eventually the monster becomes too large to contain, as it has never been properly scolded but only enabled along its course of irresponsibility, ultimately giving birth to its offspring; war, famine and all the other ‘fairy tales’.

  6. dearieme

    I used to admire much of the writing on the Pimco website but lately, led by Mr Gross, much of it has read like special pleading. Pity.

  7. Jim Schlemmer

    “Breaching either line involves long-term damage to the US economy – most notably through moral hazard. In intervening to stabilise the system as a whole, the authorities end up protecting certain people and institutions from the consequences of their ill-advised actions, thereby undermining the discipline that is crucial to market efficiency. As unpleasant as this is, the moral hazard risk is inevitable at this advanced stage of the crisis. Indeed, the question is not just what happens to irresponsible lenders and imprudent borrowers. It is also about the damage that is being inflicted on others as the financial system freezes.”

    This is typical self-serving rhetoric. First, admit that those who should be punished will likely get bailed out (and this probably includes the author). Then make a quasi-humanitarian appeal for the innocents who stand to hurt.

  8. Lune

    It’s unsurprising that of the two lines in the sand that El-Erian draws, he seems to choose the one that would bail himself out. I see that the “sanctity of contracts” only applies to homeowners, and not to Wall St. counterparties that are now going BK.

    As you’ve pointed out before, Yves, corporate bankruptcy rules allow judges to rewrite loan terms. So that line has already been crossed for companies. Why not extend the same mercy to people as well? Oh yeah, I forgot. Because El-Erian and his bond investors would be the ones getting the shaft…

  9. njdoc

    It has become official, there is now absolutely no difference between the cronies that ran the USSR, and the finance cronies running the US today. Price controls on assets will work as well as price control on cabbage. I cannot comprehend the fact that members our our big bad, bare-knuckles capatalist elite are stooping so low. We have preached to world about free markets for more than 2 generations, but now when our “wealth” is on the line, asset prices must be maintained at a permanently high plateau? More flim-flam from Wall Street! “Gentle Ben, could by up some of my crap paper please?”

  10. Elizabeth

    Pimco is out doing roadshow to institutional investors on the case for buying FNMA/ Freddie/ GNMA MBS – I actually attended yesterday so this is very timely.

    One part of it I actually buy – GNMAs at UST + 2.5% is very interesting. Yes, they are talking their book but I don’t have a problem with that.

    The speaker said two things that freaked me out.

    1) Anyone who doubts govt backing of FNMA / Freddie MBS is smoking crack. To be fair, they did differentiate from FNMA equity/ corporate debt but still…

    2) That stopping housing prices from falling more “solves everything”. This came near the end and the speaker was especially excited.
    I have a couple of reactions.

    First, I don’t have a problem with Pimco actively working with government officials to educate them on the problems they are seeing. They are the bond market and congress/ fed / treasury should be talking to them. They are starting to cross the line between education and outright manipulation, however.

    Price controls???? Are THEY on crack???

    On the other hand, I do think that getting some support for high quality MBS market is important – insanely high margins mean higher than necessary mortgage rates. While getting lower mortgage rates does not “solve everything”, it does help.

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