Are we there yet, Daddy?

There is a chorus of opinion concerning government actions to deal with the economy.  It is a chorus, because nearly everyone agrees, and they are all wrong.  It brings to mind the question that every parent has heard at the start of a trip:  "Are we there yet, Daddy?"

Let us start with a brief history of events.

What Happened

First, and very importantly, we allowed various private market actions and government facilitation to create a dangerous and highly leveraged environment.  There are plenty of people analyzing this, and we are as well.

Second, the needed process of deleveraging took place at WARP speed.  There was no one at the helm.  Existing structures were pro-cyclical, making the changes occur more rapidly rather than dampening effects, and giving everyone a chance to adjust.

Third,  those seeing the money sought the losers in the Credit Default Swap Market.  Option players purchased put options that could profit only if the company went out of business in a week or two.  When this strategy worked in the Bear Stearns case, many observed the pattern and piled on.  There are now investigations about this pattern of trading.

Fourth, distress sales at one company became the new standard, via mark-to-market accounting, for other companies.  The market bulls eye moved from one victim to another.

Fifth, the government, far too slow to recognize the problem and to act in advance, was forced into a reactive mode.  The decisions about which companies to save seemed completely arbitrary.  The decisions about whether to punish common shareholders, preferred shareholders, or bondholders were equally arbitrary.

The Result

This sequence of events created a complete freeze in the credit markets.  Why lend to a counter party who might not be there tomorrow?  The decision to allow Lehman to fail made this worse, much worse.

Events also highlighted the housing market as a cause, rather than an effect.  If we had done a better job of addressing the credit problems, qualified buyers would be part of the demand curve for housing.  Since we have not addressed the issue, the market remains dominated by sellers.  This imbalance generates continuing concern about what bottom, if any, exists for housing.

The Government Plan

The Bush Administration, led by Treasury Secretary Paulson, sought to address the key issue, the death spiral of write downs from complex securities.  Their "plan" was an outline, not a specific proposal.  It requested broad powers without specifics or limitations.  It violated the norms of Congressional and Judicial oversight.  In addition, the plan was poorly sold as a "bailout" rather than something that would establish rational markets.  The attempt to sell it embraced fear as a motivation.

The fear "worked", the market reacted, but the plan did not pass.

Everyone in government went back to work, developing a more flexible approach that provided many alternative methods.  A coalition was built.  This proved to be essential.

The immediate step was to provide a direct capital infusion for financial institutions and various government guarantees for lending.

The Result

Here are the big issues and the positive impacts — pretty good so far.

  • Counter party risk.  This has been addressed.  Our monitoring of the put markets shows no targets.
  • Thawing the credit markets.  This has been addressed.  LIBOR is declining.  Credit default swaps and other risk measures are declining.  Financial institutions are resuming normal lending.
  • Commercial paper.  This market, vital to business activity, is returning to a normal state with plenty of help from the Fed.  There will be an interval of decline in business activity, but the actions have prevented the worst case.

And here is what remains to be done.

The meat of the Paulson Plan, better explained in the hearing by Bernanke than by Paulson, was to establish normal trading and realistic marks in securitized markets.

And here is the key point…

Even the most astute market observers do not seem to understand government.  Paulson and Bernanke repeatedly stated that they wanted to "get this right" before deploying funds.  People should listen to this and understand, yet they do not.

What they hope to do is establish what we call a win-win-win situation.  This means that realistic marks on assets will be better than the current accounting standards.  Meanwhile, the purchase price will be attractive to investors (taxpayers and others joining in).  Finally, the overall economy will benefit by stabilizing assets, improving capital ratios, and permitting new lending.

Can this succeed?  No one knows yet, because they are still working on the plan.  Kashkari has explained what they are doing, and it includes price discovery, direct purchase of securities, and perhaps direct help to borrowers.  Other government programs, already passed, will help.

The unrealistic expectation was that this would start happening the day the plan was passed.  This is just silly.  Even operating quickly, the government needed to establish teams, consider the alternative methods, and get ready to launch the program.  Those believing that action should have been immediate just do not understand government or any large organization.  The expertise required must be identified and organized.

Spending money before the plan and the team was in place would have been foolish.

Our Conclusion

Regular readers of "A Dash" know our basic position.  Much of this could have been avoided by calling a "time out" on mark-to-market valuation of assets, ending the death spiral.

In the absence of this, it will take a little time for the Paulson Plan's important elements to come into play.  We expect better markets in credit default swaps, and therefore in the ABX, which trades off of these instruments.  We also expect a more stable market in CMO's and CDO's.

Since no one seems to understand either the issue or the potential in the solution, our readers have something to watch, and a source of profit.

You may also like


  • David Merkel October 22, 2008  

    We’ve talked about MTM accounting. Not going to argue it here. Aside from that, I think you are spot-on. Good piece.

  • Mike C October 22, 2008  

    I’ve really enjoyed the last several posts. Really good stuff, and I wouldn’t worry about sounding too professorial. Couple of thoughts/questions.
    1. I assume the “Gong” has NOT yet rung?
    2. What are your thoughts on the various interpretations of sentiment? We seem to be all over the map depending on what who is looking at.
    This blogger says sentiment is not bearish enough:
    Yet I can find other references that bearish sentiment is off the charts.
    I wonder if sentiment is perhaps losing its effectiveness as a contrary indicator or if too many people are utilizing the very thing they are observing and thus distorting it?

  • Jeffrey Levin October 22, 2008  

    I wanted to update some info I provided you on FAS 157 last week that will be very interesting in the coming months if the TARP program is successful in bringing out real prices. One of the most important concepts in FAS 157 is that it has at its epicenter is the idea that the FMV of any given financial asset is based on exit pricing. Everyone needs to understand that this means that a value is arrived at by placing yourself in the shoes of a seller of that asset. What do you price it at to move the asset. The obvious bias this creates in a market in which asset prices in general are decreasing is “everyone heads for the exit at the same time”. The bias is a downward mark on prices.
    However, exit pricing has the exact opposite effect/bias when prices for that same asset are generally rising. One only has to look at pricing of new houses in california circa pre 2005 to understand.
    Hope this shed some light
    Great Post Jeff

  • gray October 22, 2008  

    Jeff, I think you’re a smart guy, with good insights & I agree good things have been done over the last few weeks by Treasury, Congress and the Fed – but I’m still trying to reconcile that you spent a lot of time last year putting down the blogs predicting downside (and patronizing Mom & Pop investors who were likely to read these blogs and take their advice.)
    Why are you right now?
    Isn’t this more an issue of solvency than liquidity? Won’t the selling continue until there aren’t leveraged sellers left?
    How does mark to model avoid propping up zombies, e.g. Japan?
    In the end, I lean towards us coming out of this, as opposed to a complete global collapse…if its the former, there will be strong opportunities. If its the latter, I guess all this may not matter anymore.

  • Jeff October 22, 2008  

    Mike – You are correct. The “gong” has not yet rung. The hammer pulled back a bit further. It is a two-step indicator that is not simply based on sentiment or something like the VIX.
    Good question – I have been surprised that it has not signaled earlier.

  • Jeff October 22, 2008  

    Jeffrey – I really appreciate your observation on the “exit” aspect of FAS 157. It will be very interesting to see if any of the Treasury ideas have any real effect.
    Meanwhile, I am listening to the “Fast Money” gang opine on models. They all hate models and Dylan calls mark-to-model “a scam.” My guess is that accountants hate that assertion as well.
    Thanks again, and I hope you keep commenting on these developments. I really like to reach out to experts in each field.

  • Jeff October 22, 2008  

    Gray – You raise a lot of issues in a few words. Most importantly, the only thing I am suggesting for readers of this article is to keep a close eye on the upcoming Treasury moves, and do not be so impatient. I do not know how well their efforts will work out. None of us want to be like Japan. There is a wide disparity between where some securities are marked and the values suggested by people like Bill Gross. How can you object to a better mechanism for price discovery? We shall see.
    As to the comment about being “right”, I will consider this as a future topic. Meanwhile, I suggest that you compare some specific topics rather than form an overall impression.
    Thanks for reading and for taking the time to comment.

  • Susan October 22, 2008  

    What we need is a clarion call to get us back on track. That isn’t what we are getting from the Government. Bush’s weekly talks are less and less helpful. What we need is to get back to fundamentals. Economics, in America at least, needs the market to function properly. I think Steve Forbes’s latest article adds a lot of clarity to this discussion. Check it out here: Like Forbes says, it is capitalism that will save us, not the government.

  • The Second Last Samurai October 26, 2008  

    “What we need is a clarion call to get us back on track.”
    Forget it, losers…