There has been a ton of discussion around the collapse-that-wasn't at Bear Stearns over the weekend and the investment bank's subsequent fire sale to JPMorgan Chase & Co., but much of the market chatter seems to be missing a much larger point. In a nutshell: it's the underlying assets, stupid!
That might be a bit harsh -- but given that its a point I've harped at numerous times here on Housing Wire in the past when this site was just a little unknown blog, and given that I'm seeing major press and some bloggers yet push forward with the "liquidity crisis" meme, I think the shoe fits. After all, we're not staring at a liquidity crisis, not any more.
Not after hundreds of billions of dollars worth of liquidity pumped into the financial markets courtesy of the Federal Reserve. Not after the Federal Reserve Bank of New York opened up the flood gates for lending to investment banks. This mess isn't about market liquidity, and frankly, I don't know that it ever really has been.
Rather, this is a crisis of solvency -- and that's something that the Fed, for its heroic efforts thus far, simply can't solve. Why? Because the root of this crisis ultimately lies with housing. And, more specifically, housing prices. It's about as many as $20 billion worth of underwater borrowers in the mortgage market, depending on whose estimate you believe. It's about borrowers choosing to walk away from their homes. And it's about home prices that, so far, don't appear to have any inclination of increasing.
I'll explain why this matters more than some might think in a few minutes. But for those uninitiated to financial theory, John Hussman's Monday update provides one of the more colorful descriptions of solvency versus liquidity
that I've seen yet:
A liquidity crisis is when you write a check for more than the amount in your checking account. You suddenly realize that you need to sell a big securities position to cover it, but selling everything at once might only get you “fire sale” prices. In this case, you need a loan for a few weeks to give you time to work out of your securities position. Without that short-term “liquidity,” the check might bounce even though you really do have the assets to pay it off. In contrast, a solvency crisis is when the only asset you have to cover that check is an IOU from your Uncle Ernie, who keeps promising “I'll pay you every dime as soon as I win it back on the ponies.”
So, back to housing. Why does it matter so much? For one, because housing is such a core part of our modern financial system; for another, because we're living in a leveraged world. Micheal Levitt at Harch Capital Management, in a letter published Monday evening by John Mauldin, provides the necessary background:
It will not be the sheer volume of failures that brings the system to a standstill; the system is enormous and can sustain huge dollar losses before becoming impaired. The problem is that the global financial system is a case study in chaos theory. This is truly a case where a butterfly flapping its wings in West Africa could lead to a Category Five hurricane thousands of miles away. There are an incalculable number of derivative contracts and counterparty relationships on which the stability of the financial system hinges. All it would take is the collapse of the wrong firm or the wrong derivative contract at the wrong time to throw the wrong financial institution into crisis and force the entire system into a death spiral.
Bear Stearns was clearly one such "wrong financial institution," a counterparty to nearly every major financial firm in the world, which is why the Federal Reserve did its job and stepped in immediately to prevent what might have been an unraveling of the entire space-time continuum had it not done so. (Or at the very least, a financial meltdown that would rival anything thrown at us on Black Monday.)
The import of Levitt's point above is that we've created a highly-leveraged global financial market, and one that is also inherently unstable as a result -- HW readers should know well by now that the market's leverage is concentrated in housing moreso than most anywhere else.
The reason why this is the case shouldn't be all that hard to fathom, either: mortgages, and the derivatives tied to them, inexplicably escaped strong regulation. Until now. And if anything, the challenge for policymakers going forward will be to regulate the industry effectively without completely sucking the air out of the primary and secondary mortgage markets altogether.
But none of the above -- not Fed action, or even new regulation -- can solve for a current crisis of solvency.
No amount of liquidity can make potentially worthless assets worth something again, nor can it quickly reestablish investor confidence. In fact, trying to inject liquidity into markets when the problem isn't liquidity at all can actually have some backwards consequences for the market. Think of the case of Carlyle Capital, which saw its creditors sell off substantially all of its assets after the Fed's move to bolster liquidity -- rather than working with it to put a plan in place.
Yves Smith at the Naked Capitalism blog recently tackled the issue of unintended consequences in depth
, and quoted a reader with a dire -- but not altogether implausible -- end game:
The trigger for the collapse of the past few weeks has been the rise of agency spreads, which is the cause not the effect of all the implosions we've seen so far. So to stop the panic, the Fed would have to intervene in the agency market. But it's remaining reserves of ~$400bil is tiny compared to the amount of debt out there. Furthermore, even a full faith govt. guarantee is unlikely to stop the rise in premiums (witness Ginnie Mae debt, where spreads are increasing even with a govt. guarantee). This is partially because of panic, and partially because agency debt will have fundamentally different behavior when it includes all the extra debt Congress is talking about stuffing it with. So with that uncertainty and unpredictability, it's no wonder spreads are increasing.
As the spreads continue to claim more casualties, more firms will line up for funding (when do hedge funds get to drink directly from the punch bowl? At this rate, probably in a week or two), and the Fed, unable to say no, will have to start issuing treasuries to expand its balance sheet. Within a matter of a month or two, the Fed will find itself with a trillion or so dollars of impaired debt in a "repo" that can't ever be recalled (some because the counterparty's balance sheet is still too weak, others because the counterparty has gone BK) ...
Oh yeah, and mortgage markets will still be frozen.
Let's hope it doesn't come to that. Because at the end of the day, liquidity is only a symptom of the larger solvency crisis our mortgage and financial markets now face -- and having firms push solvency directly into the Fed's lap is a dangerous game to play, indeed.
So long as housing prices continue to fall, the value of underlying assets will remain questionable. And so long as the value of underlying assets remain questionable, our financial markets will continue to roil in a deleveraging process and a continued lack of investor confidence. While I agree with John Mauldin's recent take
that Bernanke's Fed has shown thus far it will do what it needs to in order to prevent a complete meltdown of our financial system, my concern lies with the issues above.
The Fed can't solve for technicals; it can't solve for the fact that nobody is sure what their assets are really worth; and it can't solve for the crisis of investor confidence that results. Until home prices stabilize, I think we're looking at a situation where Bear Stearns won't be the only institution to swoon. And, for the record, I hope I'm dead wrong.