By William H. Gross
Friday, August 24, 2007
During times of market turmoil, it helps to get down to basics. Goodness knows it's not easy to understand the maze of financial structures that appear to be unwinding. They were created by wizards of complexity: youthful financial engineers trained to exploit cheap money and leverage and who have, until the past few weeks, never known the sting of the market's lash.
My explanation of how the subprime crisis crossed the borders of mortgage finance to swiftly infect global capital markets is perhaps unsophisticated. What Federal Reserve Chairman Ben Bernanke, Treasury Secretary Hank Paulson and a host of other sophisticates should have known is that the bond and stock market problem is not unlike the game "Where's Waldo?" -- Waldo being the bad loans and defaulting subprime paper of the U.S. mortgage market. While market analysts can guesstimate how many Waldos might appear over the next few years -- $100 billion to $200 billion worth is a reasonable estimate -- no one knows where they are hidden.
There really are no comprehensive data on how many subprimes rest in individual institutional portfolios. Regulators have been absent, and releasing information has been left to individual institutions. Many, including pension funds and insurance companies, argue that accounting rules allow them to value subprime derivatives for what they cost. Defaulting exposure therefore can hibernate for months before its true value is revealed.
The significance of proper disclosure is the key to the current crisis. Financial institutions lend trillions of dollars, euros, pounds and yen to and among each other. The Fed lends to banks, which lend to prime brokers such as Goldman Sachs and Morgan Stanley, which lend to hedge funds, and so on. The food chain is not one of predator feasting on prey but a symbiotic credit extension, always for profit but never without trust that the money will be repaid upon contractual demand. When the trust breaks down, money is figuratively stuffed into Wall Street and London mattresses as opposed to extended to the increasingly desperate hedge funds and other financial conduits. These structures in turn are experiencing runs from depositors and lenders exposed to asset price declines of unexpected proportions. In such an environment, markets become incredibly volatile as more and more financial institutions reach their risk limits at the same time.
The past few weeks have exposed a giant crack in modern financial architecture, created by the youthful wizards and endorsed as a diversifying positive by central bankers present and past. While the newborn derivatives may hedge individual, institutional and sector risk, they cannot hedge liquidity risk. In fact, the inherent leverage that accompanies derivative creation may foster systemic risk when information is unavailable or delayed. Only the central banks can solve this, with their own liquidity infusions and perhaps a series of rate cuts.
Should markets be stabilized, policymakers must then decide what to do about the housing market. Seventy percent of American households are homeowners. Granted, a dose of market discipline in the form of lower prices might be healthy, but forecasters are projecting more than 2 million defaults before this cycle is complete. The resulting impact on housing prices is likely to be close to a 10 percent decline. Such an asset deflation has not been seen in the United States since the Great Depression.
Housing prices could probably be supported by substantial cuts in short-term interest rates, but even cuts of 2 to 3 percentage points by the Fed would not avert an increase in interest rates of adjustable-rate mortgages; nor would they guarantee that the private mortgage market -- flush with fears of depreciating collateral -- would follow along in terms of 30-year mortgage yields and relaxed lending standards. Additionally, cuts of such magnitude would almost guarantee a resurgence of speculative investment via hedge funds and levered conduits. Such a move would also more than likely weaken the dollar -- even produce a run -- which would threaten the long-term reserve status of greenbacks and the ongoing prosperity of the U.S. hegemon.
The ultimate solution must not emanate from the Fed but from the White House. Fiscal, not monetary, policy should be the preferred remedy. In the early 1990s the government absorbed the bad debts of the failing savings and loan industry. Why is it possible to rescue corrupt S&L buccaneers yet 2 million homeowners must be thrown to the wolves today? If we can bail out Chrysler, why can't we support American homeowners?
Critics warn of a "moral hazard." If we bail out homeowners this time, they claim, it will just encourage another round of speculation in the future. But there's never been a problem in terms of national housing price bubbles until recently. Home prices have been the most consistent, least bubbly asset aside from Treasury bills for the past 50 years. Only in the past few years, when regulation has broken down, when the Fed has failed to exercise appropriate supervision, have we seen "no-doc" and "liar" loans and "100 percent plus" loans. If you enforce regulation, you'll have no problem with moral hazard.
This rescue, which admittedly might bail out speculators who deserve much worse, would support millions of hardworking Americans. Those who would still have them eat Wall Street cake (as a Wall Street Journal editorial suggested, saying they should get used to renting once again) should look at it this way: your stocks and risk-oriented leveraged investments will spring to life anew. Republican officeholders would win a new constituency of voters for generations.
Get with it, Mr. President. This is your moment to one-up Barney Frank and the Democrats. Create a Reconstruction Mortgage Corporation. Or, at the least, modify the existing FHA program, long discarded as ineffective. Bail 'em out -- and prevent a destructive housing deflation that Ben Bernanke cannot avert. After all, you're the Decider, aren't you?
The writer is founder and chief investment officer of PIMCO, the world's largest bond mutual fund. This column was adapted from his September investors outlook newsletter.