An early intuitive model supporting the time distortion effects of near light speed travel imagined a beam of light bouncing between two perfectly reflective and perfectly parallel surfaces hurling through space at great speed. Today, the image and the recursive metaphor conjures up more thoughts about liquidity, its dark side and the after effects of liquidity related bubbles. In particular, it seems useful to reflect on how to clean up after liquidity related market distortions.
The term "too big to fail," is generally attributed to Congressman McKinney and was apparently uttered during hearings before the Subcommittee on Financial Institutions back in 1984. The topic back then was the then shocking $1 billion bailout of Continental Illinois Bank. A great piece on the effect of the "too big to fail" (TBTF) mentality can be sleuthed out by interested Going Private readers as a 2005 staff report by Donald Morgan and Kevin Stiroh over at the outstanding website of the Federal Reserve Bank of New York. As the authors point out:
The naming of eleven banks as “too big to fail (TBTF)” in 1984 led bond raters to raise
their ratings on new bond issues of TBTF banks about a notch relative to those of other,
unnamed banks. The relationship between bond spreads and ratings for the TBTF banks
tended to flatten after that event, suggesting that investors were even more optimistic than
raters about the probability of support for those banks. The spread-rating relationship in the
1990s remained flatter for TBTF banks (or their descendants) even after the passage of the
Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), suggesting that
investors still see those banks as TBTF. Until investors are disabused of such beliefs,
investor discipline of big banks will be less than complete.
More recently, the effect of the "Greenspan Put," or the notion that undue speculation has been encouraged by a propensity (real or imagined) of the Federal Reserve to "bail out" reckless speculators with rate cuts has a similar feel. As I am fond of coining terms, and noting that recent events in financial markets suggest that the "Put" might still be in play even in the absence of its namesake, I think that "too big to burst," (TBTB) might be a better moniker for the effect. So what is the appropriate role of regulators generally and central banks in particular when unwieldy bubbles threaten to burst?
I recently focused these pages on the topic of liquidity and the "dark side" thereof with a particular focus on the nature of surplus liquidity. Certainly, there is a "race to the bottom," as liquidity begs to be absorbed and puts pressure on market actors to place it in increasing undesirable (from a risk-reward pricing view) investments. Recapping that discussion, two dynamics influence this shift.
First, as liquidity pours into opportunities, the number of favorable risk-reward opportunities dries up, pressing liquidity ever lower on the risk-return scale. Second, as asset prices are driven up by the competition for assets, the returns available to higher risk assets diminish. (The risk premium narrows).
These two effects drive liquidity seeking the same level or returns into increasingly risky assets. These effects are, as I pointed out, complicated by the structural need for particular risk tranches to service structured products or the issuance of instruments in securitization transactions (CDOs and such) that depend on efficiency frontier portfolio design. These instruments can, therefore, create an "artificial" need for high risk assets and drive these asset prices up, even as their quality diminishes.
In the present example, and in the words of a CDO manager I quoted before: "I gotta keep accumulating collateral, and I gotta issue the liability against that collateral." This, in turn, drives loan origination into overdrive and so reduces the oversight and loan standards that less than qualified borrowers are given a pass where they otherwise never would have.
Of course, the first urge that a "too big to burst" approach reacts to is to save the many borrowers who "never should have been borrowing" and who may face foreclosure in the face of the market's whims. The Center for Responsible Lending predicts 2.2 million homes will be lost to foreclosure related to sub-prime lending practices.
Of course, this brings up several questions involving the wisdom of making poor financial decisions painless. The general populist answer to this, that borrowers were somehow "duped" by lenders into accepting loans they had no means to repay depends on a particular brand of paternalism that should leave a metallic taste in the mouths of Going Private readers. But, when such large numbers of properties are involved (there are more than 6 million "sub-prime" loans and another 6+ million "alt-A" loans, all of which are backed by collateral that is difficult or impossible to sell in a declining real-estate market) we revert back into a "too big to burst" issue. How does one balance the need to avoid dramatic shocks to the economy and the need to avoid moral hazard issues?
Regulators effectively have three options for action:
1. None. The market will deal (perhaps harshly) with the problem.
2. A Direct Bailout. This might take two forms. First, bridging the gap between home values and mortgage obligations with government funds. Second, assistance for homeowners in the form of government funds to make mortgage payments.
3. Bankruptcy Modification. Permit homeowners to write down mortgage obligations in bankruptcy.
Going Private readers will easily predict my distaste for #2. They may, however, be surprised that I could be persuaded to support #3. Consider:
Today, ironically, in a Chapter 13 bankruptcy one can discharge loan obligations on everything from boats, cars and vacation homes to almost anything else, except the mortgage on your primary residence. Your only option here is to attempt to cure any defaults pre-bankruptcy and still potentially face foreclosure. Making modifications to these restrictions could prevent "forced sale" foreclosures and permit lenders to recover more value while also supporting the populist notion that foreclosure works an injustice on the borrowers.
There are a number of other advantages to lenders that I will discuss tomorrow.
(Art Credit: Yayoi Kusama. Infinity Mirror Room--Phalli's Field (or Floor Show). 1965).