Themes For 2010 - 4 - The Government

I'm loathe to add this section to a series of articles typically directed to investors and speculators. But it is undeniable that the government and central bank actions of the past few years have had large impacts on everyone's portfolio. To a certain extent, I support the idea that over the long-term, market intervention proves irrelevant. No force is larger than the market. So even though various interventions appear to have great short-term impacts on our investments, I don't think it is instructive to look at what the government "wants" to achieve over a 5 or 10 year period and structure a portfolio thereupon.

The government/central bank duo are herd followers by definition. Bureaucracies are inherently incapable of acting proactively. They are reactive. It is for this reason that centrally planned economies always fail. You may call the market interventions of the past few years (not forgetting those over decades prior that caused the crisis) whatever you like: socialism, corporatism, crony capitalism, kleptocracy. Whatever. The term used is not important (nor are many of the terms particularly useful after decades of redefinition). What is important is the immediate objective of nearly every intervention: Price Fixing

"I don't think it's a bad thing that the bad loans occurred. It was an effort to keep prices from falling too fast. That's a policy."

-- Chair of the House Financial Services Committee Barney Frank - Oct 9, 2009

Just to nip any allegations of conspiracy in the bud, the quote above illustrates the explicit nature of these price fixing objectives. Both monetarist and keynesian (aka. neoclassical) economists are literally terrified of falling prices. Therefore, they target positive rates of inflation on a year-to-year basis. Many classical economists suggest that it is precisely this price fixing that led to most of the excesses and imbalances precipitating the crisis in 2008. If prices were mandated to rise, why not borrow money to speculate on rising prices? That is the train of logic that I subscribe to, but I won't delve further into that debate, as considerable ink could be spilled.

Thankfully, for those of us who prefer to see markets discover prices on their own, we can take solace in the fact that never in the history of price fixing has it ever achieved its objective. Not once. The reason this is so, is that in order to keep prices either above or below the level they can be sustained by incomes and revenues, a greater and greater amount of capital is required to be directed toward this goal. Eventually the cost or the political implications of doing so exceed the implied cost of allowing the market price to prevail. The price fixing scheme collapses and prices revert toward equilibrium (toward - but they never arrive). The same holds true for monopolies.

In the meantime, however, prices can be influenced by these measures. Because it is widely acknowledged that it is real estate prices that led to the deterioration of bank balance sheets, and it is a collapse of the major financial institutions that politicians and central bankers are trying to prevent, most of the price fixing schemes are directed toward supporting home prices. Let's discuss some of the schemes being employed.

Asset purchases - both the Fed and Treasury have involved themselves in the buying of trillions in mortgage backed securities. This has obscured the rate of interest (to the downside) making homeownership more affordable.

FHA balance sheet swelling - When it became apparent that Fannie Mae and Freddie Mac were essentially toxic waste dumps for bad mortgages and were put into gov't receivership, a new source of funds "needed" to be found - lest demand for mortgage securities fall and interest rates rise. Enter: The Federal Housing Administration. Their balance sheet skyrocketed and they became the buyer of a vast majority of MBS that were previously bought by Fannie and Freddie. Because Fannie and Freddie worked out so poorly, the obvious course of action was to do the same thing again - only this time, making the taxpayer the explicit buyer.

Foreclosure moratoria - numerous state governments and financial institutions have declared moratoria on foreclosures. By not allowing these foreclosures, people who are no longer paying their mortgages are being allowed to stay in their homes at no cost. The "logic" behind this is that foreclosures result in bank auctions which decimate property values, thus affecting bank balance sheets.

Modifications - numerous attempts to modify the existing delinquent or risky mortgages have all failed. They are trying to extend the mortgages even longer in duration, lower rates for the first few years, etc. Basically, they're trying to turn prime mortgages that never should have been issued into subprime or Option-ARM mortgages. Anything to avoid forgiving principal outstanding - because that requires balance sheet writedowns for the banks. Typically (and unsurprisingly), these modifications end up re-defaulting in ridiculous numbers (40-70%) after only 6 months or a year. But the purpose they do serve is to kick the can down the road. And they've been doing enough kicking to put any Detroit Lions punter to shame. Their hope is obviously that home prices will start rising again, bringing these homeowners back above water. They're dreaming.

Accounting shenanigans - Perhaps the most egregious example of market intervention has been the suspension of Generally Accepted Accounting Principles (GAAP). Admittedly, this is the one intervention I never expected in 2009. I should have known better. What has typically separated America from the rest of the world is accounting and balance sheet transparency. They threw all that away in 2009 when the US Treasury strongarmed the FASB (Federal Accounting Standards Board) to suspend FASB 157 (mark-to-market accounting). This allowed banks to value their assets at whatever price they wanted. Originally, this was going to be until yearend. Then it was extended. Had it still been in effect, as much as $5 trillion in "off balance sheet" assets would need to be revalued at their true prices. This would have made the big banks insolvent (again). This also facilitated greater market liquidity, better capital ratios, lower leverage ratios and therefore lower interest rates.

The above programs (and, to be sure, there are others) have only worked to a small extent. As of October, home prices have risen only modestly from their bottom. In year-over-year terms, they are still down approximately 6-7%. The stunning price declines of early 2008 were largely abated by the above programs. Indeed, the low interest rates encouraged many to buy their first home, move-up, or to change locations. Investors have also stepped in. I know of a number of folks here in Vancouver that have picked up vacation homes in Arizona and California. See below a number of different home price indices through October numbers.



Not exactly breathtaking, considering the many trillions of dollars that have poured into supporting prices. Surely, much of this will prove to be malinvestment, throwing good money after bad, averaging a losing trade, or whatever you want to call it.

So what of the future? If prices start falling, can't they just increase the size of the programs? Well, no. They can't.

The available pool of would-be buyers has largely already been exhausted. If someone hasn't accepted a near zero interest rate on a distressed property already, they're not likely to do so anytime soon. Additionally, the modification/moratorium games can only go on so long. After the banks offer remods, delay for months on paperwork and start to see 8 or 12 months of arrears build up, they will realize that not a penny more will be squeezed out of the mortgage. Foreclosure then becomes their best option.

But the real factor here is social mood. Populist anger toward the big banks is growing rapidly. It seems that every day we learn of one or more nefarious activities that went on between government, the Fed and the big banks. Backroom deals, non-disclosure agreements, acting with insider information, conflicts of interest, political favouritism, silencing dissidents, etc. Myself and a number of other bloggers were screaming from proverbial mountaintops that all of this was illegal and fraudulent. Nobody seemed to care at the time. They were scared. They had bought into the argument that "it had to be done... for the greater good."

But now, with the benefit of hindsight, the average person is starting to see what really occurred during those frantic days: a massive transfer of wealth from taxpayers to the financial industry. Yet the promised benefits - the unemployed getting their jobs back, investors getting their money back, etc - have not happened. In fact, as I pointed out in Part 3 of this series, the employment market continues to deteriorate. And now, gosh golly, the same financial firms are making money hand over fist and paying out bonuses like nothing happened! Taxpayers were duped. And they're pissed. President Obama's approval rating has plummeted faster than any president in the last 50 years. He makes speeches about "getting the money back from the banks" and literally nobody believes him.

An anecdote to illustrate the above: On occasion I post short rants on the CBC.ca comments forum below their articles. They have a feature that allows one to vote thumbs up or down on the comment. Usually I just post to get a feel for "the common man's" opinion. Being a libertarian in Canada doesn't often put me in good books of many, as Obama is likened to the second coming up here. But I posted in reaction to the recent plans for the Obama Administration to recover the TARP funds. I was harshly critical. I asked, "why such a focus on $800 billion, while the other $22.8 trillion in guarantees/swaps never gets mentioned?" My comment was met with unanimous approval. 88-0 last I checked. People aren't falling for this charade any more. And the Democrats are going to learn very quickly that if they don't start clamping down on the big banks, voters will clamp down on them next fall (yes, elections are only 10 months away).

The feasibility of introducing any more bailouts under these circumstances is nil. There will be violent rebellion before that happens again. Not only that, but the Obama Administration will face growing pressure to reverse as many of the bailouts as possible. They won't. At least not a significant amount. But the trend of social mood has sufficiently handicapped government's interventionist abilities. Likewise, it seems that a large portion of Americans have woken up to at least some of the Fed's activities. I see it likely that the Obama Administration will be held accountable for their actions as well.

Conclusion

A vast majority of the $23.6 Trillion in bailouts, swaps and guarantees has been directed toward supporting home prices. For the most part, they have failed. The natural course is quite obviously for home prices to continue declining toward levels commensurate with incomes and revenue generation ability. The expiration of many temporary "kick the can down the road" schemes, along with a flood of Option-ARM and Alt-A recasts, will significantly hamper bank balance sheets and eventually force further credit writedowns. Populist anger toward big bank favouritism will also limit the government and the Fed's ability to enact further legislation favourable to banks.





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