One Fix Too Many

Economic Outlook
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Just as Wall Street was celebrating the presumed
end of the latest financial crisis by pushing stocks to
record highs, proclaiming continued strong earnings
growth, and continuing to recite the mantra
“slowdown, but no recession,” Treasury Secretary
Henry Paulson provided a vivid reminder that the
housing and mortgage crisis is not over. On Monday,
October 15, while Citibank was reporting that
compared with last year’s results its third-quarter
earnings had fallen by 57 percent, the Treasury’s
“super-SIV” plan was revealed. It seems that the
Goldman Sachs alumni at Treasury—Paulson and
his under secretary for domestic finance, Robert
Steel—had become concerned that the offbalance-
sheet special investment vehicles (SIVs)
held by commercial banks might not be financeable.
That would mean that not enough investors
could be found to provide the short-term financing
necessary to sustain SIVs, the repositories of hardto-
value securitized mortgages that continue to
plague bank balance sheets.
Why, wondered investors, if the mortgage crisis
had been successfully contained, would the Treasury
be stepping out of its usual role to initiate a
discussion among banks about financing SIVs?
Depository institutions such as Citibank, Bank of
America, and JPMorgan are the Federal Reserve’s
bailiwick, and if they have problems that need
addressing and that constitute systemic risk, it is
the Fed’s role to address those problems. At best,
the Treasury’s initiative seems a gratuitous bailout
effort, while, at worst, it seems an indication that
the banks’ balance sheet problems tied to the housing
collapse were worse than had been supposed.
Meanwhile, the Federal Reserve was keeping its
distance from the Treasury initiative, saying only
that it was being kept informed.
Markets Respond to Bad News
By the end of the week, on Friday, October 19, the
twentieth anniversary of the 1987 stock market
crash, after a week of gradually falling stock prices,
the U.S. stock market fell more than 2.5 percent
while interest rates and the dollar fell sharply—all
signals that investors were taking the recession
story more seriously than they had been before the
super-SIV plan was introduced. Of course they
had some help from other factors. On the Monday
evening after the super-SIV announcement, Fed
chairman Ben Bernanke appeared before the Economic
Club of New York to present a somber picture
of the downturn in the housing market and
the difficulties associated with pricing securities
whose value is tied to the hope and expectation
that house prices would rise instead of fall. On
Wednesday, October 17, the release of September
data on housing starts and permits revealed a virtual
collapse of housing construction, with a drop
of 56 percent in starts and 43 percent in permits,
both on a three-month annualized basis. When
builders are dumping houses with the help of 10
and 20 percent price reductions, they are hardly
inclined to step up housing starts.
The bad news continued throughout the week
as earnings disappointments spread in the financial
and manufacturing sectors. Broadly, estimates for
year-over-year earnings growth of S&P 500 companies
went from about 6 percent on August 17 to
–0.1 percent on October 12. Wall Street’s hype
One Fix Too Many
By John H. Makin
November 2007
John H. Makin (jmakin@aei.org) is a visiting scholar at AEI.
about the durability of earnings growth was undercut by
third-quarter earnings reports. Adding to the likelihood
that a recession was underway or impending, data released
on Thursday, October 18, showed a sharp rise in initial
jobless claims. One of the bulwarks of the “slowdown only”
camp has been the claim that employment and wages will
hold up enough to keep consumption
growing. If employment growth weakens
further, a recession goes from a possibility
to a virtual certainty.
Alan Greenspan chimed in on Friday,
October 19, to say that the Treasury’s
super-SIV plan—which had since evolved
to a $75 billion “master liquidity enhancement
conduit” (MLEC) proposed by Citigroup,
Bank of America, JPMorgan, and
Wachovia to take on the assets of troubled
investments—ran the risk of further
undermining already brittle confidence in
besieged credit markets. Greenspan went
on to point out that the MLEC plan was
not comparable to the New York Federal
Reserve’s rescue of Long-Term Capital
Management, thereby underscoring the
Fed’s coolness toward the Treasury’s super-SIV initiative.
Clearly, at a time when the current Fed chairman, Ben
Bernanke, voiced concern as housing data deteriorated at
an accelerating pace and hopes for modest employment
growth were being dashed, it was not wise for the Treasury
to remind investors that all was not well with bank
balance sheets.
Housing Bust Still Means Recession
The bottom line on the housing and mortgage crisis has
not changed since housing prices started to soften in 2006
and have since started to fall nationally on a year-overyear
basis for the first time since the Great Depression.
The late stages of the housing boom were fueled by financial
innovations that required the securitization of mortgages
into financial instruments whose value depended on
the continued rise in house prices. The futility of pretending
that this problem has been alleviated by a 50
basis-point rate reduction from the Fed was underscored
by the Treasury’s ill-timed attempt to address ongoing
bank balance sheet problems. For optimists, the Treasury’s
effort was a jarring reminder that the problem was not
over, as they had assumed it was. For the pessimists, the
Treasury’s initiative was an occasion to reiterate how
intractable the problem of valuing derivative mortgage
securities has become. How, they asked, can a group of
banks put together a fund among themselves to purchase
mortgage assets whose value remains indeterminate?
The SIVs are items that the banks placed off their balance
sheets in order to avoid regulatory restrictions on
bank investments in risky assets. The
problem is that the banks will be obliged
to further tighten credit when they take
those risky assets back on to their balance
sheets unless they can arrange financing
for them in the commercial paper market.
But participants in the commercial paper
market, aware of the extreme difficulty of
evaluating the assets in the SIVs, are
unwilling to roll over the financing for
those vehicles. The Treasury’s plan essentially
suggests that the banks should put
together a fund to purchase only the best
of the assets in the SIVs in order to somehow
restore confidence. But the best of
the SIV assets are not the problem.
Beyond that, why should the banks need
the help of the Treasury to construct a
fund to purchase attractive assets?
The basic problem is much simpler to understand than
the esoterica attached to the valuation of SIVs or Treasury
intervention in facilitating their financing by banks
that already own them. The housing bubble has collapsed
and will continue to deflate. Even without the existence
of exotic and hard-to-value mortgage derivative securities,
every housing downturn since World War II has
resulted in a U.S. recession. Given that this housing
downturn is more intense than most and has involved
greater compromise of the balance sheets of major banks,
there is no reason to suppose that a U.S. recession in
2008 is not at hand. The only way to avoid it would be a
massive easing stimulus by the Fed that resulted in a
reversal of the drop in house prices—a virtually impossible
undertaking—which would surely entail the return of
the serious inflation that the Fed is pledged to avoid.
The rest of what has unfolded since the financial market
panic in August has been an exercise in concerted
denial. The arguments have taken various forms: There
will not be a recession because employment growth will
hold up and households will continue to boost consumption.
Corporate earnings will hold up well and thereby
support the stock market. The drop in the dollar will
stimulate exports enough to cause the economy to avoid
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Every housing downturn
since World War II
has resulted in a U.S.
recession. Given that
this housing downturn
is more intense than
most, there is no reason
to suppose that a U.S.
recession in 2008
is not at hand.
recession. In the week leading up to the twentieth
anniversary of the 1987 stock market crash, these hopes
were undercut and fears of a recession returned with a
vengeance. As I have already noted, stock prices fell, but
the dollar and interest rates also fell—all in anticipation
of weaker earnings and more aggressive Fed rate cuts to
try to cushion the onset of a recession. Through the rest
of 2007, stock prices and the outlook for the economy
will, no doubt, continue to oscillate, but they will do so
around a declining trend line.
Macroeconomic Laissez-Faire
The rush back into risky trades after the Fed’s policy
moves in August and September, coupled with the Treasury’s
proposed super-SIV intervention in the credit markets,
has brought us to a moment of truth concerning the
outlook for the U.S. economy. At issue is a cost-benefit
analysis of government intervention to avoid recessions.
The extreme degree of risk-taking behavior after 2003
that resulted in a widely noted underpricing of risk created
a housing bubble in the United States. The housing
bubble raises questions: Should the economy be allowed
to operate in an environment in which
lenders make undocumented loans to
borrowers on the basis of virtually no
information regarding the borrowers’
ability to repay the loans? Is it adequate
for the orderly operation of credit markets
for lenders to make undocumented loans
only because they merely originate the
loans and then resell them into packages
of securities, many of which have been
labeled triple-A or low-risk by credit rating
agencies compensated by those packaging
the securities in the first place?
To put it more bluntly, we have discovered that
widespread underpricing of risk has resulted in a housing
bubble the unwinding of which will cause a U.S.
recession. In the name of avoiding a recession, should
the financial decision-makers involved in creating the
bubble be protected?
Ben Stein, an optimistic economist with an admirably
broad view of the world, which has included regular
appearances on TV quiz shows and hilarious displays
of droll humor in movies, said it well. While suggesting
that the U.S. economy probably is not in serious trouble,
he notes that “some extremely worrisome things have
happened and are now being revealed and worse are yet
to come.” These are the problems that I have discussed
over the past several months that likely will lead to a
U.S. recession.
What I suggest here is that a U.S. recession may be
necessary to push financial decision-makers back toward
the appropriate valuation of risk. Stein is more direct:
The vicious, cruel truth is that some very greedy,
selfish, and yes, stupid men made fortunes on deals
that were economically and/or ethically wrong.
(Why else hide them off balance sheets or abroad?)
They got immense fees, stunning paychecks, and
the inheritance of maharajahs. . . . The ones at the
top aren’t fired, or if they are fired are fired very
rich. (Never mind that silly mouth music from
Citigroup about “the year of no excuses.”) . . .
Despite what looks to me like a breathless lack of
disclosure, I have not seen any lawsuits by the
Securities and Exchange Commission against any
of these big money center princes or principalities—
not to mention criminal investigations from other
law enforcement authorities.
Instead of the investigations that Stein
suggests, we have seen an effort by the
treasury secretary and the under secretary
for domestic finance to bail out the banks
as a response to the bursting of the housing
bubble. In so doing, they have cynically
suggested that they are really just
thinking about the unfortunate American
homeowners, especially those victimized
by subprime lenders who might lose their
homes. Many subprime borrowers are
already in bankruptcy proceedings, as a
glance at any newspaper will show.
The issue of a post-bubble American recession attributable
to inadequate risk analysis by private-sector
decision-makers is really an issue of macroeconomic
laissez-faire. Economists are quick to argue that government
intervention on a micro basis can distort resource
allocation. So too can excessive government intervention
on a macro basis. If decision-makers conclude that
when excessive risks are undertaken, either the Fed or
the Treasury will step in if necessary to keep the economy
on an even keel, then such intervention will lead to too
much risk-taking. Excessive risk-taking will result in
more volatile growth and inflation, which, as we have
learned over the past twenty-five years, is to be avoided
- 3 -
A U.S. recession may
be necessary to push
financial decisionmakers
back toward
the appropriate
valuation of risk.
if long-run stable growth of output and productivity is to
be encouraged.
I am suggesting here that the cost of avoiding recession
after the biggest housing bubble in American history
has burst is too high. It will involve rewards to those who
took excessive risks that will only result in more underpricing
of risk in the future, and therefore larger bubbles
and, ultimately, a more unstable economy that underperforms
expectations.
I am not suggesting that the Fed should
stand idly by as economic growth slows
while inflation remains stable or falls
further. The Fed’s decision to reduce the
fed funds rate by 50 basis points on September
18 was tied to an observation that
the economy was slowing rapidly and
that the disruptions in financial markets
would exacerbate that slowdown. An
aggressive move was necessary to initiate
preemption of a self-reinforcing, dangerous,
and dynamically unstable downturn
whereby a housing mortgage crisis slows
the economy; a slower economy intensifies
the housing mortgage crisis; and the
economy, in turn, slows still further. To
avoid that outcome, the Federal Reserve
will undoubtedly be reducing interest
rates more rapidly in coming months,
probably down to 3 percent by the middle
of next year.
The Federal Reserve should continue
to keep its distance from Secretary Paulson’s super-SIV
proposal. Citibank, the major beneficiary of a superfund
bailout, is a depository institution and therefore the direct
responsibility of the Federal Reserve and not the Treasury.
The super-SIV proposal, as already noted, appeared on
the very day that Citibank announced a sharp 57 percent
drop in its third-quarter earnings and during a week when
Bank of America and Wachovia also reported very weak
earnings. Clearly, the Fed shares former chairman
Greenspan’s view that the SIV problem is not akin to the
Long-Term Capital Management meltdown in which it
intervened in October 1998. Perhaps the criticism at the
time regarding the moral hazard problem entailed by the
Fed’s intervention, even at that point, has left a mark on
the Fed’s thinking.
Recession Beats Alternatives
At the end of the day, the problem facing the U.S.
economy—a collapse of a housing bubble with attendant
damage to overall growth—is acute but not chronic. The
way to avoid a recession—having the Fed print money
and push house prices back up—is not a viable option.
The Treasury plan is inappropriate because it rewards
problematic undervaluation of risk by the heads of major
banks, and it is unworkable because any
sale of assets to a superfund will involve
pricing them at realistic (much lower
than par value) levels. The holders of
derivative securities are anxious to avoid
that outcome and so, ultimately, will not
move forward with the superfund plan.
The positive economic aspect of the
U.S. housing bubble collapse is that it will
lead to a recession. As I have stressed,
every housing sector downturn since
World War II, most of which have been
less intense than the current downturn,
has done just that. The normative aspect
of the analysis is that given the circumstances,
a recession is the most desirable
outcome. To repeat, avoiding it would
involve so much government intervention
and so much reinflation by the Fed that
risk-taking would be encouraged even further,
resulting in an even larger bubble and
a larger subsequent recession.
The route to sustainable growth is not continued
bailouts for bankers and financial innovators who have
contrived ways to undervalue risk. Japanese bank regulators
demonstrated that by allowing banks to hide toxic
waste on their balance sheets during Japan’s “lost decade”
of the 1990s. If discouraging such behavior entails a recession,
then it is clear that risk underpricing has become all
too widespread. The same is true if avoiding a recession
means still more risk-taking, higher inflation, or both. If
the Federal Reserve continues to moderate the economic
slowdown tied to credit problems with appropriate—
non-inflationary—interest rate cuts, the economy will
return to a viable, stable, long-run growth path like the
one that has generated an unprecedented period of
prosperity during the last twenty-five years.
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#22364
The cost of avoiding
recession after the
biggest housing bubble
in American history has
burst is too high. It will
involve rewards to those
who took excessive risks
that will only result in
more underpricing of
risk in the future, and
therefore larger bubbles
and, ultimately, a more
unstable economy.