September 4, 2007

Well, I’ll tell everybody straight off: there ain’t no indices being published today. I don’t have time; I’ll have to update tomorrow.

Bush’s profferred help for hapless homeowners is attracting considerable comment. Willem Buiter takes the view that “A rate cut is unnecessary. Congress will swiftly augment the Bush bail-out, adding a fiscal stimulus worth, say, 0.5% of GDP. The anticipation of relief on both the fiscal and monetary side is likely to be enough to normalise credit conditions.” Most importantly:

By subsidising excessive and imprudent borrowing, it reinforces the moral hazard faced in the future by low and middle income Americans pondering the size of the mortgage they can enforce (if the market-friendly President Bush is willing to bail us out today, would a more market-sceptical President Barack Obama or President Hilary Clinton not do so again tomorrow?)

There is a reasonable prospect that Federal legislation and Federal regulation and supervision of the housing finance industry will be changed in such a way as to reduce the likelihood of the excesses, the mis-selling and the misrepresentations that became rampant especially during the past 5 years or so.

It is, unfortunately, quite likely, that the legislative and regulatory changes we will get will amount to a Sarbanes-Oxley-style regulatory overshoot, that is, regulation of the ‘if it moves, stop it’ variety. This will discourage future lending to low-income or credit-impaired would-be homeowners even when such lending is fundamentally sound.

Tom Graff also worries about the moral hazard issues.

Meanwhile, at the Jackson Hole conference, sub-prime and related issues continued to be front and centre. Professor Hamilton of Econbrowser argues, in effect, that moral hazard has already happened; that the Government Sponsored Enterprises (GSEs) in the States that guarantee mortgages are woefully undercapitalized and are viable only due to an implicit government guarantee.

While I think that preserving the solvency of the GSEs is a legitimate goal for policy, it is equally clear to me that the correct instrument with which to achieve this goal is not the manipulation of short-term interest rates, but instead stronger regulatory supervision of the type sought by OFHEO Director James Lockhart, specifically, controlling the rate of growth of the GSEs’ assets and liabilities, and making sure the net equity is sufficient to ensure that it’s the owners, and not the rest of us, who are absorbing any risks. So here’s my key recommendation– any insitution that is deemed to be “too big to fail” should be subject to capital controls that assure an adequate net equity cushion.

It also might be useful to revisit whether Fed regulations themselves may be contributing to this misinformation. Frame and Scott (2007) report that U.S. depository institutions face a 4% capital-to-assets requirement for mortgages held outright but only a 1.6% requirement for AA-rated mortgage-backed securities, which seems to me to reflect the (in my opinion mistaken) assumption that cross-sectional heterogeneity is currently the principal source of risk for mortgage repayment.

A tax on GSE mortgages has been proposed, but I’ll need a bit more convincing on that matter! I like the regulation of capital better – it fits into the existing regulatory framework in a better way, allowing for more efficient use of capital. 

Professor Taylor – of Taylor-rule fame – argues instead that the culprit is loose Fed policy in the 2003-05 period. He was supported by Martin Feldstein, who feels the Fed should act more proactively on asset bubbles – such as, it is now clear, US housing – on the grounds that the rewards for correctly identifying an asset bubble in real time outweigh the risks of being wrong. This has very immediate implications for the correct Fed response to a housing-led slowdown: should the Fed assume the worst, and avoid a recession at the risk of easing too much, or should it react to data from the real economy as it arrives? After all, there has been minimal indication of damage in the manufacturing sector, but there are some indications consumers are running scared.

It certainly sounds as if the conference was fraught with interest! The basic debate can be cast as:

“Rick is basically saying, ‘We can’t lean, but we can clean up,”’ White said, referring to Mishkin by name and raising his voice to make his point. “I think we can make equally strong arguments for `You can lean and you may not be able to clean up.”’

For now, count me among the ‘wait for data to come in’ and ‘regulate capital usage of the GSEs’ camps. For now.

There has been plenty of damage to economic sectors closer to the epicentre of the financequake. Novastar is cutting back sharply on new loans and is desperately trying to survive on its servicing income. This role may achieve higher prominence (and fees, undoubtedly) now that regulators are urging loan workouts. First Data, a junk credit, is going to have to pay through the nose for loans.

Brad Setser continues his attempt to understand China’s USD holdings … an interesting and potentially lucrative specialty! The Chinese have not yet weighed in regarding Credit Rating Agency regulation, but Josh Rosner has. This last one is interesting because it’s the first balanced (which is to say, non-hysterical) approach to the topic I’ve seen. Mr. Rosner wants the following reforms (bolded; my comments in italics):

  • ratings for structured securities use a different scale—say, numbers instead of letters—to differentiate them from ratings for corporate and municipal bonds. Cosmetic. Possibly useful if it can be shown that such securities have a genuinely different risk/reward profile than regular bonds, but it raises the spectre of different scales for each sector of the economy.
  • He believes the agencies need to step up the training for analysts Training is a motherhood issue. Every time there’s a train wreck, we hear more calls for increased training of engine drivers. I’m OK with requiring some kind of registration for credit analysts, but (having fulfilled my regulatory educational requirements) I’m extremely dubious about the potential for this having much value.
  • and should be compelled to re-rate transactions regularly rather than monitor them haphazardly. “Haphazardly” is rather a loaded word and I’d like to see more details about why it was chosen. This strikes me as micro-management.
  • Furthermore, he thinks efforts should be made to distance the agencies from Wall Street. He proposes that any ­ratings-agency employee involved with a structured-finance deal for a Wall Street firm should have to wait a year before being able to join that firm. Such a waiting period already exists for auditors. No, no, a thousand times no! In the first place, acting as a credit analyst is simply an advisory function; there is no legal force to the analysts’ work. I definitely support such rules for employees of regulators – they have all the power of the State behind them when they exercise their function – but to extend this to credit analysts is going too far. They are advisors, only advisors, and should not be subject to employment restrictions that are any more stringent than those that exist for other advisors.

Redemption demands have led one fund to close, but the managers are now trying to put together a vulture fund. An internal Deutsche Bank unit is being shut down. And so the wheel spins…

US equities had a great day on speculation the Fed will cut two notches to 4.75% at their next meeting; Canadas were also strong on hopes fears that hurricanes in the Gulf will be destructive.

It was a quiet day for Treasuries, with some steepening; Canadas followed.

I hope to update the indices, performance and volume tables tomorrow.

Update, 2007-09-07

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 4.96% 4.91% 2,034,989 15.52 1 -0.0816% 1,043.7
Fixed-Floater 4.88% 4.79% 93,337 15.83 7 +0.0654% 1,024.3
Floater 4.93% 2.68% 74,544 7.99 4 +0.0560% 1,038.5
Op. Retract 4.84% 3.96% 77,682 2.97 15 +0.0471% 1,025.2
Split-Share 5.12% 4.63% 103,543 3.89 13 +0.2057% 1,046.7
Interest Bearing 6.24% 6.73% 66,580 4.59 3 -0.1022% 1,039.8
Perpetual-Premium 5.49% 5.13% 93,011 6.80 24 -0.1083% 1,028.3
Perpetual-Discount 5.08% 5.12% 265,023 15.30 38 +0.1694% 977.4

4 Responses to “September 4, 2007”

  1. […] Ratings agency employees shouldn’t be able to jump to investment banks they have helped to structure transactions.: This suggestion came up in the September 4 commentary. No! A thousand times, no! In the first place, there is no indication that this is, in fact, a problem. Secondly, it will enforce draconian restrictions on the career choices of analysts. And thirdly, it is inappropriate because agency analysts have no power to force anybody to do anything; they give advice. Full stop. This sort of restriction is appropriate for regulators but is not even applied to them. Regulation Services trumpetted the fact that their employees were jumping to the banks for fat paycheques as evidence of the impressive skill of their employees; let’s fix up this aspect of revolving-door regulation before going after mere advisors! I will, perhaps, give a certain amount of additional credence to a particular agency if they tell me that each analyst has “gardening leave” in their contracts; to give such a matter of judgement the full force of law would be abuse of regulatory authority. […]

  2. […] NovaStar, mentioned here on September 4 is in the news again: NovaStar Financial Inc., the subprime home lender trying to survive by conserving cash, scrapped plans to pay a dividend on 2006 profit and will forfeit its real estate investment trust tax status as a result. […]

  3. […] Look carefully! Do you see the bit that has Greenspan blamed for the housing bubble? He was relying on forecasts, wasn’t he? […]

  4. […] The Fed Jackson Hole conference was discussed in PrefBlog on August 31 and September 4; a great deal of debate there centred on the proper role of Central Banks when confronted with a market pricing problem. I suggest that the Fed is terrified of a lock-up in the interbank markets and, by the new liquidity injection, is taking steps to ensure that such a lock-up doesn’t happen. This may thought of as the downside analogue of ‘leaning against the bubble’. […]

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