I’m Taking an Awful Risk Here… This Had Better Work…

Is the TARP working? Are rate cuts working? Stimulus package? Is the TSLF working? What about the GSE conservatorship? Is that going to work? What about my lucky rabbits foot?

Pundits love to debate whether any given program will “work” or not. But in these debates, the participants tend to talk past each other. Take the capital injections made through the TARP. One side can argue that this scheme is “working” because of falling LIBOR and CDS spreads on banks. The other side can claim that this program does nothing to address the root problem (foreclosures) and will not allow the U.S. to avoid recession.

Of course, they’re both right. And hence this is a boring and frankly unproductive debate.

Most of the programs and plans currently enacted (my rabbit’s foot aside) are aimed not at preventing a recession. That ship has sailed. To see what I mean, think about the basics of the business cycle.

Recessions tend to be the result of some misallocation of resources within the economy. Since reallocating resources takes time, there is an inevitable period where the economy operates at less than full capacity. The greater the adjustment needed, the deeper and longer the recession.

In the period leading up to this recession, we had a overinvestment in housing. Even if nothing else had happened, the adjustment in housing probably would have resulted in a recession. Loans were made that shouldn’t have been made. Houses were built that shouldn’t have been built. We need to clear the excess investment (houses).

However, we also had a financial economy which had become reliant on low volatility and continuous access to liquidity. After the failure of Bear Stearns, Wall Street was forced to decrease their leverage positions. Continuously falling marks, especially on housing assets, only increased their need for additional equity. This added to the already painful economic adjustment underway.

The came September. The rapid failure of the GSEs, Lehman, AIG, Washington Mutual and Wachovia changed everything. The urgency for firms to deleverage was dialed up to 11. In addition, common forms of debt financing, including securitization, have completely dried up. Most firms can fund their activities using other forms of financing, but it will be expensive and potentially painful to make the transition.

So now we need to adjust to a large number of foreclosures, a deleveraging financial system, and a rapidly changing funding structure. That is a recipe for a deep and long recession.

There is nothing the Fed or anyone else can do to prevent this process from occurring.

But the Fed and Treasury can help to ease the transition. Programs like the commercial paper funding facility can help firms that relied on asset-backed commercial paper to transition to other secured funding. Offering FDIC insurance on new bank debt allows banks to roll-over maturing debt, buying them time to deleverage through normal cash flow.

But these programs cannot, will not, and I content were never intended to “fix” the financial system. We will get through this, but we need more time.

As an investor, if you continue to think in terms of “solutions” from the government, you are missing the point. Even putting my libertarian ideology aside, the government cannot “solve” a misallocation of resources. The best thing it can do is provide liquidity to make the transition as painless as possible.

So in thinking about whether some scheme is going to “work” or not, think in terms of avoiding unnecessary economic adjustments. Think in terms of easing the transition. Don’t think in terms of avoiding a recession or reversing the steep losses in the stock market. Nothing can stop that now.

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About Accrued Interest 118 Articles

Accrued Interest provides unique, expert insight to developments in the U.S. bond market. It is written by an anonymous professional working in the field.

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