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Monday, March 24, 2008


a new resolution trust corporation -- and a warning from japan


The only tool left may be for the Fed to help facilitate a Resolution Trust Corp.-type agency that would buy bonds backed by home loans, said Bill Gross, manager of the world's biggest bond fund at Pacific Investment Management Co. While purchasing some of the $6 trillion mortgage securities outstanding would take problem debt off the balance sheets of banks and alleviate the cause of the credit crunch, it would put taxpayers at risk.

``An RTC-type structure is interesting, and it may not be that much of a burden on taxpayers in the long run,'' said Barr Segal, a managing director at Los Angeles-based TCW Group Inc. who helps oversee $80 billion in fixed-income assets. The government should purchase the mortgages and reissue ``debt that's backed by the U.S. government and there you go, you've unclogged the drain,'' he said.

``Something like that would be very helpful, but the Fed was not designed to and shouldn't assume a huge amount of risk on behalf of taxpayers,'' said Alan Blinder, a Princeton University professor and former vice chairman of the central bank. ``That should come out of the elected parts of the government, which means the administration and Congress.''

President George W. Bush and Treasury Secretary Henry Paulson have resisted calls urging the use of government funds or guarantees to stem a record amount of mortgage foreclosures, the root of the financial crisis, preferring that the markets resolve the trouble. Bush said March 15 he wanted to avoid ``bad policy decisions'' that would do more harm than good.

... For Pimco's Gross that's not enough. ``If Washington gets off its high `moral hazard' horse and moves to support housing prices, investors will return in a rush,'' he wrote in a note to investors published Feb. 26. Gross, who runs the $122 billion Total Return Fund from Newport Beach, California, didn't return calls seeking additional comment.

An RTC-like entity may not be ``the best idea, but maybe it's the idea that gets us through this,'' said New York Life's Girard. ``The likelihood of it happening has certainly increased.''

... ``In a sense they've done that already with Bear Stearns,'' Michael Materasso, senior portfolio manager and co-chairman of the fixed-income policy committee at Franklin Templeton Investments, said of the government taking on the risk of owning mortgage securities. ``This was not just a temporary situation. The process has begun, the question is how far can it go?''

it's been pointed out that gross is talking his book, and he surely stands to benefit from government support for the mortgage-securities market. but no less a personage than paul volcker sees the high likelihood of such a move. so does economist brad delong, who notes that this is now a stage 3 financial crisis and that the alternatives are a depression, a big inflation, or a massive public intervention.

gross, however, either does not understand the mechanics of house prices (very doubtful) or is being disingenuous when he claims that the government can "support housing prices" by buying packaged loans even in a massive public intervention (whereas is might do so in a large inflation, by debasing the currency and allowing a big fall in real prices to occur as nominal prices are essentially static). what the government can do by such an act is help deleverage the money center banks, investment banks and hedge funds that are holding these illiquid, loss-making securities, recapitalizing them by buying their troubled assets as artificially inflated prices. importantly, the same holds for fannie mae and freddie mac, which increasingly appear fit for nationalization in total.

Faced with losses this large, some analysts have suggested that more capital is clearly on the menu. And not just a small amount, like an extra $2 billion — we’re talking gobs of it. The Wall Street Journal reported earlier this month that Friedman, Billings, Ramsey & Co. analyst Paul Miller had estimated that Freddie requires $38 billion of capital, while Fannie would need $41 billion.

While those numbers may represent an extreme, both GSEs earlier this week said they would “begin a process to raise significant capital,” as part of an agreement between OFHEO and Adminstration officials. Freddie Mac has already gone on record saying that it won’t dilute existing shareholders by issuing more common stock.

for gross to be correct, not only the banks but the whole shadow banking system would then have to use their newfound capital strength to... dive right back into the huge leverage and widespread fraud that characterized the mortgage market in recent years! that is exceedingly unlikely to happen, in my view.

recapitalized banks are very likely instead to follow the mode of past bubble-burstings (a precedent set very clear to japanese technocrats if not americans) and find ways to allocate capital to economic sectors that have been the best and safest -- not the worst and most troubled -- recent performers. ken fisher may have read that ahead of most everyone, if it comes to pass, calling for heady performance among mega-caps with large cash balances, international exposure and very high levels of creditworthiness.

moreover, gross papers over a more fundamental concern with a large-scale government bailout of housing -- that of turning a national deleveraging crisis into a vastly worse global currency crisis. in delong's terms, this would be a massive public intervention unintentionally precipitating one of the other two options. this is what japan's finance minister means when he says:

Mr Watanabe warned unless swift and appropriate action was taken by world leaders, the financial market turmoil could lead to a severe dollar crisis.

He said the world’s huge excess liquidity has started flowing out of the US. If that flow were to be extended, it could lead to unprecedented problems.

“One thing is to fix the hole in the bathtub,” he said. “[But] we must recognise that the current crisis is not as straightforward as past dollar crises.”

... The minister said that while the US credit turmoil was structurally similar to Japan’s at the time of its bad debt crisis, there was an important difference in that risk in Japan was contained in the banking sector. In the US, it had been dispersed widely into other areas of the financial industry. So “it is not clear how big the hole [in the US] is because the fire has spread to products other than securitised products”.

the even more important difference that goes unremarked upon here is that japan's policy responses to the lost decade were backed by a very high domestic savings base -- unlike the united states, japan did not have to borrow internationally to finance bailouts. the government of the united states is already nearly $10tn in hock, with half that amount owed internationally. while this is not outrageous as a percentage of american gdp, it is a very large figure in terms of global assets. a massive new flood of treasuries could provoke an international dollar/treasury repudiuation and force a dollar crash as the much-feared carry trade unwinds. indeed, recent severe weakness in the dollar reinforces the minister's remarks. citigroup has very ominously warned of worse to come from that direction as yen deleveraging continues apace, and it's hard to calculate what the impact of a massive flood of new government debt into already-strained international debt markets would have on the currency.

it is paramount to realize that japan's central bank is one of the largest holders of treasury debt in the world. yves smith notes that the minister's highly unusual statements amount to a demand that the united states use the treasury to bail out wall street banking.

The Japanese comment is effectively a statement that significant actors in the US financial sector are bankrupt and will need to be recapitalized. Again, that is a shocking diagnosis to make in a public forum. Wantanabe says that the US banking system will need to get new equity from the government. The delay in recapitalizing Japanese banks (it was hard to win over the public) is considered within Japan the biggest reason for the length of their economic crisis

The Japanese are as nicely as they possibly can telling the US that we are in a terrible mess and we need to get on top of it ASAP. This is a blunt warning. I am sure the significance of the Japanese attempt at tough love will be lost.

japan apparently still fears far more for the death of american consumption than for the value of its central bank holdings. so probably do others. but private buying of american securities has entirely gone, brad setser notes, and smaller central banks are slowly giving up on the united states in favor of investment closer to home.

Central banks from 16 Asian nations may invest more of their $1 trillion of foreign reserves in the region's debt as Federal Reserve interest-rate cuts reduce returns on U.S. assets.

``This is something that most of us, that are not yet investing in, will be looking at,'' Bangko Sentral ng Pilipinas Governor Amando Tetangco said in a March 23 interview in Jakarta. There can be ``some kind of shift'' to Asian sovereign bonds, Central Bank of Sri Lanka Governor Ajith Nivard Cabraal said in a separate interview on March 22, after a weekend meeting of policy makers from the region.

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