The Subprime Mess, Daily Briefing, Dec. 5, 2007
By Arnold Kling
Actually, I will not post on this daily, but I think it deserves frequent comment.Steven Pearlstein writes,
As part of the unwinding process, the rating agencies are in the midst of a massive and embarrassing downgrading process that will force many banks, pension funds and money market funds to sell their CDO holdings into a market so bereft of buyers that, in one recent transaction, a desperate E-Trade was able to get only 27 cents on the dollar for its highly rated portfolio.
Meanwhile, banks that are forced to hold on to their CDO assets will be required to set aside much more of their own capital as a financial cushion.
…This may not be 1929. But it’s a good bet that it’s way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001.
I am inclined to disagree with the last paragraph. The tech bubble created trillions in illusory wealth. I am pretty sure that the amount of illusory wealth in the housing market is smaller.
A large part of E*Trade’s basket of assets was securities backed by high-quality mortgages — loans to homeowners with strong credit ratings and reasonably large equity cushions. That could raise troubling questions on Wall Street about the true value of “prime” mortgage assets, especially when they need to be liquidated in a hurry.
…Even if E*Trade got nothing — not a cent — for anything but these top-quality mortgage securities, it still sold $1.35 billion in prime mortgage assets for $800 million, or less than 60 cents on the dollar.
How many firms are so desperately short of cash that they will have to sell securities backed by prime mortgages for far less than their reasonable long-term value? And how is it that there are not enough potential buyers among banks or other firms to provide better liquidity?
I would like to see the subprime securities issue resolve quickly. Mark down those securities, get through the foreclosures as expeditiously as possible, etc. My thinking is that whatever spillover damage that subprime foreclosures are going to have on house prices is something I’d like to confront soon and put behind us.
Spillovers in financial markets are a different story. I would wait a month or two to see if there are any more E-trade sorts of situations. If there are no other shoes to drop (meaning, companies needing to dump securities backed by perfectly reasonable collateral into thin markets), then I would say that we have gotten past the crisis from a financial point of view.
If we see more fire sales in the next month, then maybe some regulatory forebearance should be allowed. I am thinking along the lines of allowing banks to make a case for not marking to market securities that are illiquid but otherwise backed by solid collateral. This might help prevent an unnecessary cycle of contraction.
The excessive asset-price increases caused by some past monetary expansions — especially the induced rise in the prices of real estate — provide a further reason to use fiscal as well as monetary policy. By cutting the fed-funds rate to just 1% in 2003 and promising that it would be raised only slowly, the Fed contributed to the sharp rise in house prices and the market’s current weakness. A mixed strategy that included a prospective fiscal stimulus would have reduced the Fed’s perceived need for a sustained negative real fed-funds rate, and would therefore have produced a more balanced expansion of demand.
Now is surely a time for such a two-part strategy of expansion.
This argument is too cute for me. Feldstein asserts without proof that expansionary fiscal policy has less risk of producing bubbles than expansionary monetary policy. Again, I think the first priority ought to be allowing the housing market to find its equilibrium. If housing construction starts to turn up a year from now, then a fiscal stimulus might not look like such a wise move.