Monday, January 11, 2010

Being Ben Bernanke During the Minsky Moment

A large proportion of the growth during the 2002-07 period was debt-financed demand as evidenced by the substantial rise in the ratio of public sector debt to GDP (as well as the declining ratio of incremental growth to debt growth). While the credit boom included both corporate debt (+$3 trillion), most of the debt growth occurred in the household sector (+$5 trillion).

Most of this incremental household debt found its way into the credit market in the form of securitization (RMBS, ABS). Historically, highly-rated securitizations were valued using in-house intrinsic-value models due to the absence of a secondary market for structured product (due to its opacity and complexity). This convention worked as long as structured product performed in accordance with expectations and credit losses were within the ranges suggested by their ratings.

Two shocks brought the securitization engine--and credit markets more generally--to an abrupt halt. These shocks were (1) the poor performance of subprime-related mortgage backed securities and their CDO derivatives; and (2) a coincidental and highly disruptive change in the accounting paradigm for structured product from "mark to model" (intrinsic value) to "mark to market". 

This accounting change, imposed at the end of 2007, disregarded the absence of an efficient, liquid secondary market for hard-to-value complex securities. While some intrinsic-value models may have been over-optimistic, the futile and fictitious mark to market convention created massive paper losses which exceeded the earnings capacity and capital resources of the financial system, thus transforming a credit problem into an accounting-driven capital crisis.

The closing of the securitization market meant that household debt could no longer grow in the double digits as it had from 2002-06, but would in fact have to contract due to mortgage amortization and defaults. The debt-financed growth engine was thrown into reverse. The Minsky Moment had arrived, when, unable to refinance, corporate and household borrowers were forced to sell assets in order to meet debt obligations. 

The withdrawal of credit to the household and corporate sectors pushed the real economy into the sharpest and steepest recession in the postwar era, which further threatened the performance of the securitized product of the boom era.

Following the collapse of Lehman and the near-collapse of the financial system as a whole, there was no longer a private market bid for private sector debt. In order to prevent another Depression, the central bank and the federal government stepped in to maintain credit flows. 

The Fed increased its balance sheet by ~$2 trillion (still small in the context of $14.5 trillion GDP) and the Federal Government increased its liabilities by ~$2 trillion. The GSEs were kept afloat by capital from the government and securities purchases by the Fed.

Massive lending by the Fed and the GSEs and deficit spending by the US have prevented a meltdown. But the private credit markets for household debt have not reopened. Instead of buying mortgages or RMBS, institutional investors are buying government and corprate debt. The real economy won't recover unless household deleveraging can be reversed.

The challenge facing the Treasury/Fed and their brain-dead socialist dependencies (FNMA, FHLMC, GNMA, VHA, FHLB) is whether they can or will continue to buy mortgages on the scale required to sustain recovery. Already the hawks on the FOMC are pushing for an exit strategy long before victory is even in sight. This would be analogous to FDR asking Eisenhower for an exit strategy the day after D-Day. 

Because the securitization market has not revived, not only is there no viable exit, it may prove necessary to grow the FRB/GSE balance sheet by another $1 trillion in 2010. There is no public discussion of this need. All eyes are on the exit. 

The central issue is not whether massive easing this is good or bad in a platonic public policy sense, or whether it could prove inflationary, or whether there is an easy exit strategy. The issue is whether the authorities mean it when they say that they will do whatever is necessary to restore and sustain economic growth.

Few economists understand these issues better than Chairman Bernanke. He has studied and criticized the nonfeasance of both the Depression-era Fed and the post-bubble BoJ. In both cases he has made clear that deflation is a monetary phenomenon and a measure of central bank failure. 

The problem is, as I see it, is that he desires to (1) maintain FOMC consensus, which gives the irresponsible hawks a veto; and (2) retain respect and support for the Fed on Capitol Hill, Wall Street and abroad. The radical measures that Bernanke may be required to take threaten both of these goals. 

It may be remembered that it took the total collapse of the US economy and financial system for the government to abandon the gold standard, the shibboleth of the day. Hopefullly, it will not require the collapse of Western civilisation to wean the FOMC from its death-wish embrace of "price stability". 

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