Liquidity vs. Minor-Solvency vs. Major Solvency Crises--No--Panic vs. Interest-Rates-Are-too-High vs. The-Financial System-Is-Totally-B***ered Crises--No--I Need Better Names!

Calculated Risk has insightful comments on my Project Syndicate article. Here is one:

Calculated Risk: Delong: Three cures for three crises: I don't think it's quite that bad. Even if the losses for investors and lenders reach $1 trillion (a possibility), I think the financial system can absorb those losses. Sure, some players might disappear, and others might have to sell significant assets (or dilute their shareholders), but I don't think the choice is between serious inflation and depression.

Still, I think the "Yikes" tag fits...

And CR points us to Mark Thoma, who points us to an even-more-insightful than usual piece by the brilliant and hard-working Greg Ip:

Economics Blog : Liquidity Threat Eases; Solvency Threat Still Looms: As 2007 winds down, the much-feared year-end liquidity crisis appears to have been averted thanks to aggressive action by central banks.... Libor rates have dropped sharply since Thursday... [but] are still high relative to the expected federal funds rate because banks still have an ongoing demand for cash to fund new obligations and residual concerns about each others’ creditworthiness.

Nonetheless, as Lou Crandall, chief economist at Wrightson ICAP LLC said today, “Things are unfolding smoothly.” The first quarter is likely to start much as the fourth quarter did, with reduced concerns now that the statement date has passed. Balance-sheet strains will continue to create concerns about the price and availability of short-term funds, Mr. Crandall said. But for the most part, “We’ve moved beyond... liquidity concerns. The focus has moved to that part of the financial fallout that central banks can’t address through technical operations.”

In other words, as 2008 begins, it’s solvency, not liquidity, that threatens the economy... a likely decline in housing prices that will further undermine credit quality. Making banks more confident of their own ability to raise funds is not going to resolve a generalized shrinkage of lending driven by declining collateral values.

looming threat is an expected hit to housing demand as Fannie Mae and Freddie Mac impose new fees to buy or guarantee mortgages once considered prime... customers putting down less than 30% on a home and with credit scores below 680. Bianco Research... estimates “over one-third of prime] home buyers are going to get ‘crunched’ by tougher standards, much bigger downpayments and interest rate ’surcharges.’” The fees apply to mortgages the companies buy after March 8....

“We believe home prices will continue to fall,” Bianco wrote. “This is the cause of the credit crisis.” The collapse in issuance of mortgage-backed collateralized debt obligations is itself merely a result of falling home prices.

On the other hand, maybe home prices don’t have much further to fall.

I do badly need better names for my three-part classification of financial crises:

• Liquidity crises
• Solvency crises that are easily cured by easier monetary policy that boosts asset values
• Solvency crises that aren't easily cured by easier monetary policy

I also need to figure out what kind of crisis we are having. Let's get out the envelope and start scribbling...

Since 2000, roughly 3 million extra new homes have been built over and above those that would have been built if things had followed long-run trends. Figure $300K per extra home. That's an extra $900 billion of investment in housing that's 100% leveraged and currently occupied by the 3M American households that were priced out of the pre-bubble housing market. If the lenders foreclose on those 3M, they then will find themselves trying to sell the 3M houses to 3M other households that are even less-rich and less-credit worthy. So the best strategy is for the lenders to sit down and negotiate. Maybe the Fed can help more by lowering interest rates further. But some chunk of that $900B is going up in smoke.

Then there are all those who saw their houses rise in value and took out home-equity loans. We know there are a lot of them--household savings rates did not get driven to zero by accident. But how many of them are going to default on their home equity loans, and how big will the losses the lenders eat going to be?

My guess right now is $500B in total loan losses for both tranches of the crisis. But that's just a guess, and an unbacked guess at that...

Comments

[Michael]

Why didn't this posting appear in the usual sequence in delong.typepad.com?

[Mason Louie]

Brakes, Gas, or Pray

Financial markets are scared things are going too fast? No problem, hit the brakes.
Financial markets are scared about driving over a shaky bridge, hit the gas.
Financial markets are scared they just drunkly drove off a cliff, well hit the gas and pray!

What I don't like about the pray solution is that there's no check against hyperinflation. It's like the old joke about finding an elephant in Africa: The programmer starts at the south tip and walks west to east moving north laterally. The master programmer does the same thing, but puts an elephant in north Africa. Although hyperinflation isn't as bad as full on depression, its severe derrangement of people's expectations should warrant more wariness than simply shrugging.

To that end, somebody, probably the government (cause it's the best available organization for the job judging by history), should put an elephant, a parachute for our wayward auto, in place before things go too awry. Once upon a time, this parachute was named DARPA and from its unplanned, but not totally unexpected outcomes, Bill Clinton ushered the 1990s (Reagan had the same players on the same field, but built nukes instead). The US should be in the business of financing not only small crucial innovations through fiat credit, but raw reality-altering scientific revolutions, lest it find itself on the bad end of a political one (oh wait, that's already happening).

However, the purpose DARPA once served is (thankfully) no longer necessary and thus it's a fraction of its former self. Still there remains large important problems worthy of our attention and suitable as a last ditch insurance policy for reckless inebriated captains of finance & industry. I once joked with a friend that the US should fund a Martian Terraforming project to really fire up the scientific juices rather than waiting for silicon to peter out. Nowadays, why worry about Mars when we have a perfectly pressing problem right here in our own backyard. We should fund a Terran Terraforming project.

The problem with current ecological research is that it's fair too piecemeal. Which is because we don't know how ecological systems really work. Yes we know carbon is a problem, but what do we do when we solve our carbon problems and find things are still getting worse? Or if it stabilizes, the world is no longer friendly for human habitation? For scientists to ask, then answer these risky important questions, they either have to be rich or have financial backing from a less result-oriented organization. Last time I checked, "scientist" and "rich" were mutually exclusive and research funders not only want a definite result before loosening the purse strings, but a successful one at that (why bother then, with the research funder, go straight to venture capital? Look what it did for Google!)

Coming back around to economics from my science safari, rather than inflate assets and hope something will stick, we should focus on producing real value, real stuff worth owning, real betterment of our fellow man, which warrants bigger price tags. What is worth owning nowadays? A beautiful house with a crushing mortgage? A stock certificate which might optimistically regain its purchase price in 40 years? A government bond yielding peanuts? A bar of gold sleeping in a crypt also yielding peanuts? Or a world where our children need not taste the droughts, famines, and shortages we're boiling today?

[Measure for Measure]

Here's another distinction:

Financial crises which damage the financial infrastructure. The classic example is the 1932-33 US banking crisis. Absent effective intervention, these can lead to depression, since market economies depend upon financial intermediation. Recommended treatment: whatever is necessary.

Financial crises which do not damage the financial infrastructure. Examples include the 1987 stock market crash. These events damage the economy via the wealth effect, lowered confidence, higher uncertainty and repressed investment as firms postpone decisions pending a better idea of where the economy is headed. Ordinary and limited expansionary policies treat such situations without undue inflationary risk.

[walkingtheline]

Mason,

Let's not romanticize government-led research. Funding academic research is fine, but only to the extent that it comes with openness so that research findings and results are accessible to innovators outside the academic system. This simply does not happen with NIST or DARPA.

[Slocum]

"Then there are all those who saw their houses rise in value and took out home-equity loans. We know there are a lot of them--household savings rates did not get driven to zero by accident. But how many of them are going to default on their home equity loans, and how big will the losses the lenders eat going to be?"

It doesn't seem like it's the holders of home equity loans that are going to be the problem but rather those who refinanced into the same low-equity, temporary teaser-rate mortgages that were being used for new houses. So it doesn't seem like there is really any meaningful distinction between buyers of newly constructed homes, vs buyers of existing homes, vs refinancers of existing homes.

The real question, it seems, is how many people have negative equity combined with loan payments they can't handle, and I'm not sure the amount of excess construction during the bubble really gives us any kind of handle on that.

[Ottnott]

Liquidity crisis
Solvency crisis
Heh. The obvious third type is an Insolvency Crisis - that is, a Solvency Crisis that is too big to contain.

More seriously, I don't think your third type of problem fully captures the residential mortgage problem.

Although home prices rose far too high when viewed in terms of such measures as household income or equivalent rent, I would argue that many buyers at peak prices were acting quite sensibly.

Lunacy? No. Because some of the speculative buyers weren't purchasing a home at all. What they were getting were low-cost or no-cost call options on the market value of the home. If prices moved against them, they could simply default on the no-money-down loan. Unethical buyers even could (and, from what I've seen, often did) hold the property for months without making a single payment. If prices rise, they pay what they owed before the foreclosure process started. If prices fell, they give up the home.

The cost of the homes were irrelevant to those who were buying these call options. And the irrationality was on the lending side, not the buying side.

The crisis here is a broken financing system. The most appropriate cure most definitely is not inflation. The cures are transparency and regulatory oversight, with plenty of the latter needed to ensure enough of the former.

As an example of the needed transparency, buyers of the securitized mortgage debt might have hesitated to reach for those extra few basis points of yield had they known that the AAA rating was based on a model that assumed that (a) home prices would continue to rise from levels that were already far above historical peaks in terms of incomes and rent, and (b) a FICO score developed to predict borrower behavior regarding credit-card debt would predict borrower behavior regarding mortgage payments on overpriced homes.