Thursday, October 18, 2007

The Government's Plan for Dealing with the Credit Crunch

It can be informative to ask simple questions. Amidst all the details, complexities and nuances of the subprime mess and the credit crunch, let's ask a simple question. Why is the Treasury Department involved in dealing with this situation?

As you surely know, several major banks, along with Treasury, have proposed the formation of a special investment vehicle (which we call the "Super Conduit") to purchase mortgage-backed assets from structured investment vehicles (SIVs) affiliated with banks that have run onto the shoals of the subprime mess. These purchases would help the SIVs repay commercial paper that the affiliated banks have guaranteed. If the banks were required to pay on their guarantees, they'd have to book a bunch of losses because the SIVs' assets may not be valuable enough to repay the banks for fulfilling the guarantees. It's not clear this proposal will work (see our preceding blog at Whether or not it does, there remains the question why the Treasury Dept. is in the picture at all.

The Treasury Department doesn't have primary regulatory responsibility for banking. The Federal Reserve and other banking agencies have that hot tamale. The Treasury Department doesn't have primary responsibility for regulating the financial markets. The SEC and the CFTC perform those duties. While the Treasury Dept. has authority to regulate U.S. Treasury securities auctions, and require reports of cash transactions with banks (if they exceed $10,000), these areas are hardly affected by the subprime mess. So Treasury doesn't have a whole lot of legal jurisdiction here. Does that mean we have government employees doing work they don't have to do? Pigs would waltz on the Moon first.

There appear to be two basic reasons why Treasury stuck its nose into this particular latrine. First, the banks sponsoring the Super Conduit are acting a bit like a cartel. The Super Conduit, from a banker's perspective, could be viewed as "stabilizing" prices of CDOs. Others might characterize it as a group of powerful banks getting together and fixing prices (instead of letting them go way down where their competitors could buy them for a song). That could violate the antitrust laws. However, if the banks involve the government in their discussions, they might be able to rely on a legal doctrine called Noerr-Pennington to dodge antitrust liability.

Second, and probably more important, the Treasury Dept. appears to be lending its stature to the discussions. In the uncertainty and opacity of the subprime mess, leadership is sorely needed, and Treasury may have been one of the few parties that could provide it.

One might ask why the Federal Reserve, which was instrumental in organizing the 1998 bank bailout of Long Term Capital Management, isn't actively involved in the Super Conduit. There could be a simple reason. The Fed is the primary regulator of all major U.S. commercial banks. It can also ensure that the major investment banks have access to credit (by telling the commercial banks to lend to the investment banks, which is more or less what the Fed did after the 1987 stock market crash). If the Fed took the lead in these discussions and encouraged all the major banks to participate, it could be viewed as implicitly guaranteeing the financial viability of the Super Conduit. That is a can of worms the Fed wouldn't want to buy.

Treasury, on the other hand, doesn't have the legal authority to make or fulfill any such guarantee. So it's in a position to lend its stature and engage in moral suasion, without having to deal with claims of a guarantee.

It all sounds so cute and clever, no?


The fact that Treasury, a department of the federal government with no significant jurisdiction in the matter, involves itself with the subprime mess tells you that the government has no plan for dealing with the crisis. It never saw the credit crunch coming, and didn't prepare for it. It purposely turned away from regulating the derivatives market and hedge funds, to the point where it didn't have even basic information about the scope and extent of the problems. The government didn't realize how abusive to customers some mortgage brokers and mortgage companies could be. It didn't realize how esoteric and detached from financial reality CDOs had become. It was unaware of the tremendous amount of leverage hedge funds were using to invest in CDOs. The leverage created hair trigger conditions for a downturn if CDOs took even relatively small losses (since leverage would magnify the impact of the losses). It didn't understand how far the bank-affiliated SIVs and conduits had gone in pursuing a strategy of borrowing short term (with commercial paper) and investing in longer term CDOs. This strategy is particularly weird considering that the yield curve was inverted for much of the past few years (so the cost of borrowing would squeeze profit margins unless the SIVs and conduits took larger and larger risks in search of earnings).

Consider the government's response to the crisis. The Fed first turned up the liquidity spigot, then made the largely symbolic move of lowering the discount rate, and finally announced its surprise half-point fed funds rate cut. Now, we have Treasury, with no jurisdiction, stepping in as a sponsor of the Super Conduit. Do we get the impression that the government is winging it? Are these people making it up as they go along? Does this bring back memories of the halcyon days of youth, when the conversation in the huddle of a touch football game might sound something like, "okay, Tommy, you go to the left down the sideline, and Jimmy, you go out on the right and slant in, and Pete, you line up on the right end and come back to me so I can give you the ball for a reverse if I want to, but maybe I'll keep the ball and throw it, or maybe I'll run with it around the end, or . . . "

The primary responsibility for the subprime mess and the credit crunch doesn't rest with the government. It falls on the mortgage brokers, mortgage companies, investment bankers, hedge fund managers and other players who saw the real estate markets as the newest and best source of fast money, the easy way, get it while you can, and the devil take the hindmost. But the process of holding these parties accountable will take a while, in many cases proceeding with all deliberate speed in the courts.

The government was a facilitator par excellence of all this exuberance, what with the Fed's easy credit policies and the tax code favoring speculative investment over old fashioned working, earning, thrift and prudence. So the government should help with the cleanup. But it is going to need luck if it keeps throwing Hail Mary passes and tries to be the first player in 60 years to score with a drop kick.

The government has no choice except to muddle through the current situation. However, just to prove that bureaucrats can move up the learning curve, a more proactive regulatory regime for the problem children of the subprime mess and credit crunch would brighten the future of the financial markets.

Crime News: burglar cleans up mess he made.

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