The Sky is not Falling

I watched Geithner's speech a couple days ago and had a very similar reaction to the market. Namely, I still can't believe how little detail was provided. As a quick aside, it reminded me of Lehman Brothers before they declared bankruptcy. Dick Fuld announced a conference call in which he would lay out their plan for getting through the crisis. Almost the entire investment community dialed in. Mr. Fuld proceeded to tell us about the steps they were thinking about taking. The market was shocked. They expected to hear something concrete and got a roadmap. It was uncomfortable watching the Geithner speech because I had the same sensation as during the Lehman call. As much as most investors cringe at all the government intervention, they generally want to believe that the government can successfully reverse the downward economic spiral. Most of us also think the government is terribly inefficient and so slow that most of their stimulus will kick in once the economy is already recovering. Sadly, Geithner did nothing to counter that belief.

Despite my own frustration with government intervention and the ugly political posturing, here is my argument for why I am optimistic that the government plan is finally on the right track and will prevent a doomsday outcome.

In a nutshell, we are finally attacking all the key problems. We are recapitalizing the banks AND trying to remove the overhang from bad assets AND trying to stop home price depreciation AND trying to slow consumer deleveraging AND trying to create jobs. It is easy to criticize the government in retrospect for not tackling all these issues from day one, but realistically, the cost of doing so is enormous and is only worth the risk now that we know how bad things are. Would you really have wanted your government committing trillions of dollars to a problem that might develop?

Banks: I understand that mainstreet hates the idea of bailing out the same institutions that contributed to the current mess, but I think it is silly to single out one group when so many are guilty (Banks, non-bank originators, Wall-street securitization engines, rating agencies, greedy borrowers, stupid investors, regulators, polititians, basically everyone) Even if you are still fixated on the banks, you have to come to terms with the reality that a modern economy requires an operating financial system that converts savings into credit. That means we need a functioning and healthy banking system and capital market.

I remember having a somewhat heated debate with a colleague when the TARP was first announced. My argument at the time was that we needed to help remove the overhang of the bad real-estate assets because banks need to know they are well capitalized before they can really start lending again. If we simply infused equity, the banks would still not know if they would be well-capitalized next quarter because the assets continued to deteriorate, so they wouldn't lend. My argument was that the government could help fix the bad asset problem, which would allow the banks to know how big the final losses were, which would quantify how much additional capital they needed to raise from the private sector. Ironically, Paulson reversed course and infused equity without solving the bad asset problem. The key point remains the same; the banking system needs to be recapitalized AND have the bad asset overhang removed. I would prefer that the the private sector provide the capital, but at least both issues are being addressed.

I don't know enough about the private/public bad bank proposal yet to have a guess about whether it will work, but that is not the only possible solution. The governement could guarantee assets after a first loss peice as they have already done with a few specific banks. The key is to stop separating the asset question from the equity question and recognize that they are intertwined.

Housing and Deleveraging: Geithner and Congress are also focused on stabilizing the housing market. Every foreclosure puts another home on the market (increasing supply and pushing prices down) and generates another loss for a bank or MBS investor. Every time housing prices go down, another stretched mortgage borrower owes more than they could sell for, which makes it almost impossible to refinance or sell. Addressing foreclosures attacks the supply side of the housing market. The government is also trying to generate new purchases on the demand side of the equation. I've said this before, but I think the government is essentially trying to artificially loosen mortgage underwriting standards to prevent a quick consumer deleveraging. We all know that consumers are making less money and spending less money. Part of the money we spend is from income and part is from borrowing. The fact that getting a mortgage is so difficult is in and of itself hurting spending and pushing up the "savings rate". We need households to be able to take out new mortgages (especially first time buyers) in order to slow the pace of aggregate deleveraging.

Jobs: And finally, the government stimulus package is designed to create jobs, which give households money to spend, which is good for business, which allows them to hire more people... This one is pretty obvious in my mind so I won't spend more time on it.

Fly in the ointment: One of the most common concerns I hear is that the government will be dramatically increasing its debt level; which seems manageable now given the rush to safety and the resulting ultra-low treasury rates. What if treasury investors get spooked and push rates up? For what it is worth, I am worried about this too but am struggling to think through all the dynamics and offsets. This line of thought very quickly becomes geo-political (will China keep buying treasuries etc.) in addition to financial and economic. I think what is missing from this debate is the likelihood that total US debt (including business and consumer debt) will continue to decline while government debt specifically goes up. In order to be really worried about this, I think you have to assume that demand for debt instruments will fall, in aggregate, faster than the supply of debt. If I want some of my money in a fixed income investment, I can choose between a government bond, a corporate bond, a consumer loan-based bond or other asset-backed instruments. Corporations and consumers have recently seen the damage that can come from too much leverage, so I find it hard to believe that those categories will be growing for several years. Unfortunately, I also think demand for debt instruments will decline in aggregate as risk appetites are re-discovered. I think predicting the relative magnitude of these trends is almost impossible, but I think it is a risk. Do I think Treasury yeilds are artificially low and are likely to go higher? Yes. Do think that they will go up so much that it forces a default or currency devaluation? Probably not, but this question is too hard for me right now.

Conclusion: Despite the lousy speech, Congress is set to pass the stimulus bill and the Treasury and Federal Reserve are focused on the right things. As an investor, my thesis is that we avert doomsday and start gradually pulling out of this recession.