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 March 5,
2009 - The recent Term Asset-Backed Securities Loan Facility (TALF)
announcements bring to mind Einstein's definition of insanity - "doing
the same things over and over again and expecting different results". It
is well documented that securitization of loans, use of leverage, and
government intervention in the free markets helped inflate assets bubbles,
fostered a culture of debt, and distorted the efficient allocation of limited
resources in our economy. If you want a good real world example, Fannie Mae
bonds guaranteed by the government, backed by a pool of subprime mortgages,
and bought using borrowed money (leverage) touches most of the bases. In the
past, we have outlined the problems associated with the government guarantees
and distortions of the free market. Our government created Fannie and Freddie
with the noble goal of helping more people become homeowners. The following
is a summary of a September 8, 2008 CCM article Welcome to the Mortgage Business, which
highlights the law of unintended consequences:
Mortgages
carry risk. If you place a guarantee behind a mortgage-backed security, like
Fannie and Freddie bonds, there really is no risk to the investors who keep
supplying capital to the mortgage market. As investors supply more capital to
the system, more questionable mortgages can be written and builders can keep
building more houses. Why is anyone guaranteeing mortgages? Placing a
guarantee behind a risk asset creates moral hazards. Why? Because the loan
originators do not care if the mortgage holder keeps making their payments
since they can sell the mortgage to Fannie and Freddie, who in turn will
place a guarantee behind the mortgage. The guarantee behind Freddie and
Fannie bonds were and will continue to be a source of moral hazard. If you
remove the guarantee and Fannie and Freddie from the entire system, banks and
investors would treat mortgages as risk assets, which is what they are. Instead
of propping up Fannie and Freddie with taxpayer funds and guarantees, both
firms should be gradually removed from the system. The free market can supply
mortgage capital to people who have the necessary debt-to-income ratios and
credit history. Loans should be made to people who can pay them back. The
current state of the mortgage and housing markets clearly illustrates the
results of placing guarantees behind risk assets, which is what Fannie and
Freddie do. Fannie and Freddie are part of the problem, not part of a
solution. Selling a house to someone who is unable to make the payments is
not helping anyone and is not part of the American Dream.
In March
of 2009, the Federal Reserve's TALF attempts to correct the problems of the
day by encouraging more of the same. The highlights of the plan to
"return the credit markets back to normal" include:
·
The Fed offering cheap credit to large players in the private
sector including hedge funds and private equity firms.
·
Businesses are encouraged to loan money to small businesses and
consumers to purchase more cars, trucks, heavy equipment, houses, commercial
real estate, or anything using a credit card.
·
Businesses that make loans can securitize them (sound familiar?)
and sell them to the hedge funds and private equity firms who buy them using
leverage as high as 12-to-1 (sound familiar?). The capital to leverage is
provided by our government.
·
Hedge funds and private equity firms will not have to post any
collateral for their Fed loans, making it even easier to overextend
themselves with credit.
·
With the government providing a backstop, investors can,
according to the Wall Street Journal (03/04/09), "walk away from a deal
if they are unable to repay the Fed loan, losing only their initial
investment." TARP (a.k.a. the taxpayers) will absorb the initial losses.
The Fed
is no longer the lender of last resort, but has become the only lender. For
those not keeping tabs at home, the Fed has doubled its balance sheet assets
to an eye-popping $1.92 trillion in the past year via the creation of
numerous emergency and "temporary" credit programs. Under TALF, the
Fed is becoming a giant prime broker for hedge funds and private equity
firms. Many of the real world prime brokers effectively ran themselves out of
business with securitized loans and use of high leverage (e.g. Bear Stearns
and Merrill Lynch). The Fed hopes hedge funds and private equity firms can be
enticed to buy more asset-backed securities with favorable loan and repayment
terms.
Just as a
government backing of mortgages distorted the housing markets, resulting in
overbuilding and "homeowners" who should have been renters, the
TALF program will distort the free market by effectively subsidizing specific
types of loans related to a limited number of industries. There is a reason
the "shadow banking system" has dried up - supply and demand. Given
the state of the economy and consumers' impaired balance sheets, demand for
loans has naturally decreased while the risk of making the loans has increased.
Rather than accept the natural consequences of poor decisions, the government
is hoping to get the whole cycle started again with TALF as a primary driver.
The
supply of asset-backed securities (ABS) is already overwhelming a market with
few interested buyers. Increasing the supply of securitized loans, which is
what TALF will do, is not going to help stabilize prices in a market that is
having trouble finding a bid. The use of leverage basically creates
additional buying power and helps distort asset prices. Leveraged buying
power has contributed to distorted prices in many markets including housing,
stocks, commodities, and the ABS market. The recent crash in asset prices
shows us what happens when the artificial demand of excessive leverage is removed
from the system. TALF hopes to create more artificial demand via leverage in
the ABS market.
The Wall
Street Journal (03/04/09) confirms Einstein's definition of insanity:
"The
government, in essence, is trying to save the economy by turning to the very
financial engineering that spun out of control during the credit boom."
Government
backing of programs, subsidies, and guarantees to limit losses, lead to
distortions in the way capital is allocated in our economy. Evidence of this
is already surfacing. In a Washington Post article, Stephen Schwartzman, head
of the Blackstone Group, said his firm has decided to look into buying up the
assets offered in TALF, though the firm has never bought the securities
before. The government's program will pull capital away from more productive
free market projects as favorable terms change the behavior of market
participants. Look no further than the glut of unsold homes to see the
effects of inefficient allocation of capital due to government
"incentives".
The TALF
program and basic concepts were originally announced in November of 2008. Due
to the complexities of the program, the first TALF loans to hedge funds and
private equity firms will be made available on March 17, 2009. The stock
market has not been encouraged by the basic concept of TALF. We will have to
see how assets prices react once the program is up and running. The early
returns reinforce the need for a disciplined risk management and stop loss
discipline. The S&P 500 recently broke through long-term support, an
event that should not be taken lightly by investors. The longer the S&P
500 stays below 741, the less likely it will be TALF is the rabbit the
markets are hoping policymakers can pull out of their bailout hat.
Rather
than letting nature take its course and see consumers begin to pay down
excessive levels of debt, the TALF program encourages the accumulation of
more debt. Recessions purge bad debt from the system and punish poor decision
makers and managers. The United States needs to check itself into credit
rehab rather than go on another credit bender that will only create more
bubbles.
Ciovacco Capital
Chris
Ciovacco is the Chief Investment Officer for Ciovacco Capital Management,
LLC. More on the web at www.ciovaccocapital.com
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