Government, Crises, and Time Frames
Returning from vacation, where (once again) we monitored markets and traded, but did not find time to write, we are struck by an overwhelming market consensus. The leading market pundits criticize government for not being “proactive.” There is overwhelming criticism of anything that can be labeled a “bailout.” When the plan actually calls for banks to share the losses, as noted in today’s Wall Street Journal, that is also deemed to be wrong.
The pundits have missed the biggest government mistake — the timing of FAS 157. At some point an astute academic will review this history and explore why the SEC sanctioned a self-inflicted death spiral.
Let us agree that the mortgage securitization process went too far. Oversight was lacking. Incentives for all participants were misguided. Leverage become excessive.
The real question confronting us is what to do.
The Pundit Approach
Many pundits, with various motives, write extensively about “moral hazard” and what the government should be doing. They note that government was slow to act.
This attitude reflects a lack of understanding of the policy-making process. Let us suppose that we took some of the leading market pundits and put them in the legislature a year or two ago. What would they have done?
The real issue is that democratic legislatures are essentially reactive. Hot-shot fund managers could not have developed consensus solutions in the absence of widespread recognition of a problem.
It is easy to write opinion columns about what policymakers have done wrong. The writers get a lot of exposure. Self-serving proposals by those who have sold short stocks like Fannie (FNM) and Freddie (FRM) get a lot of attention, but they are not realistic.
Understanding Government – A Better Road to Profit
Most pundits are engaged in a losing battle, but they do not know it yet. The innovative actions of the Fed, surprising to most observers, have stabilized emergency borrowing by financial institutions. Bipartisan action has resulted in a stimulus package and a housing bill. The Bush Administration has made clear their preference for a solution involving existing government agencies and the GSE’s.
Don’t fight it. The federal government is bigger and stronger than you are. By indicating support for agency paper, the system of subsidizing mortgage lending has been reaffirmed. Today’s announcement of the “covered bond” proposal is another example.
There are plenty of signals that the government, while reactive, is aggressively so. There is recognition that stabilizing lending and helping with potential foreclosures is a key to restoring demand in the housing market.
It is true that many — perhaps most — do not see the relationship between restoring a normal housing market and their own interests. Many people want to see others lose, punishing those who were not as smart.
That is not how government officials view the situation. They take the perspective of the common good, and craft proposals that minimize the bailout aspect while aiming at overall stability. The people in government are not stupid, but they are generalists. They see the problems in systemic terms and react to crises. They use existing institutions to solve problems because it is too difficult to create new ones. They are also (correctly) motivated to act before the elections.
We believe that the new legislation will back the GSE’s without massive dilution of existing shareholders. The reason is simple. The Administration hopes to privatize this market, but realizes that this is not the moment. Putting the screws to existing shareholders will not facilitate this objective. George W. Bush does not want the nationalization of the mortgage market to be part of his legacy.
Investors should listen carefully to Treasury Secretary Paulson, an astute Wall Street veteran. Expect to see even more ideas like the covered bonds.
Our own move has been to buy Fannie Mae (FNM) and write high-priced calls against the stock. We expect the policies to help banks as well, as more normal lending conditions are restored.
Do not confuse your political viewpoints with what will work as an investment.