Decent article from (gasp!) The Street on the Credit bubble and the role of GSE's:
thestreet.com
Of Minsky and Financial
Spandex
By Jim Griffin
Special to TheStreet.com
Originally posted at 6:33 PM ET 7/16/00 on
RealMoney.com
Spandex.
That's what occurred to me during my reading of
columns one and six in last Friday's Wall Street
Journal. But before I crib from the Journal, let me quote
from The New Palgrave Dictionary of Economics on the
topic of "money in economic activity." In one of those
"does money matter?" sorts of philosophical inquiries
that give economists a pointy-headed image (regular
folks are in no doubt on the question), the Palgrave
cites, among others, a favorite financial theorist of mine,
Hyman Minsky.
In Minsky's view, firms issue liabilities to
finance production based on uncertain
(and not necessarily self-fulfilling)
expectations about future profitability. As
an economic expansion develops, these
expectations become more buoyant, and
more liabilities are issued. This process
gradually erodes the quality of the
liabilities because there comes to be a
larger and larger probability that profit
realizations will not in fact allow all the
commitments to be met. Each firm tends
to move toward thinner and thinner
margins of equity in its financial position;
firms that are reluctant to follow this policy
find themselves severely punished
competitively in the short run. The
deterioration in the quality of liabilities sets
the stage for a financial crisis, in which
many firms face difficulties in meeting their
commitments, and new lending is
extended only on much tougher terms. In
the absence of State intervention to
substitute its liabilities in part for lower
quality private liabilities, the resulting
collapse of the financial system has
strong repercussions on levels of
economic activity as firms find it difficult to
finance new productive outlays.
If you think this reference is opaque, you should try
reading Minsky in his own words. Thick going, which
must be why his works were never translated into
Japanese. I presume they weren't, or Japan's financial
system might not be the perfect Minsky cautionary
omen it is today.
The front page of Friday's Journal was like a short
course in Minsky. Column one was about Fannie Mae
(FNM:NYSE - news) and Freddie Mac (FRE:NYSE -
news) and the issues that may potentially arise as
these investor-owned but "government-sponsored"
enterprises (GSEs) have grown out of proportion to the
underlying investments they were meant to finance.
According to the column, 70% of all fixed-rate
conforming mortgages made last year were purchased
by these two lenders. Some now worry that these GSEs
have outgrown their apportioned turf. Bound by charter to
the home mortgage market, they have a limited range of
permissible uses of funds. But supported by an
ill-defined government sponsorship, they have
exceptional ability to raise funds.
If you find this set of conditions to be reminiscent of the
savings and loan business of yore, you may be among
the worriers. Driven by investors to perpetuate their past
growth rates, Fannie and Freddie have eased loan
underwriting standards and repurchased their own
securities in the market. The purpose of such tactics
appears driven more by the interests of the
investor-owners than by the central reason for being of
these enterprises, which is to facilitate home ownership
in the U.S. That, at least, is the allegation of those,
including some in Congress, who would like to rein in
these Brobdingnagian institutions.
Deeper concerns are that implicit "government backing"
enables them to raise funds virtually without limit, but
regulatory constraints placed on their utilization of funds
may lead inevitably to over-investment in residential
capital and distortions to capital allocation generally.
Over-investment tends to lead to retrenchment as night
follows day, so there is a concern about the potential for
general financial crisis, or another taxpayer bailout
("substitution of liabilities") if, in a more austere
environment, too big a share of those loans on the
books prove to be nonperforming. The voters won't like
another taxpayer bailout like the one that was
necessary to clean up the S&L mess -- but they love
cheap mortgage credit, so Congress must step carefully
in considering any changes to the GSEs' charters.
Booming issuance of GSE liabilities has lead to buoyant
conditions in the home-building business and, as Fannie
and Freddie have come to dominate home finance, they
have almost surely displaced competing capital into
adjacent uses, so easier access to credit -- the reason
for being of Fannie and Freddie -- spreads from
mortgages to virtually all other lending.
Column six was even more diverting. Journal staffers did
some digging into just how the Great Internet Bubble
(their characterization) came to be inflated by the
competitive slippage of underwriting standards for IPOs
among the investment banking community. Don't read it
if you're squeamish, but here it is in distilled form:
"...[T]he Internet Bubble was a product of basic avarice
and tactics that smacked of the boiler room. From Wall
Street pro to fledgling daytrader, all joined hands in a
giddy game of lowering standards, pushing out IPOs and
trumpeting prospects, with little regard for a company's
true long-term -- that is to say, more than three months'
-- outlook." The article described a sort of race to the
bottom in underwriting standards by competing
investment bankers in order to get or hold share in the
highly lucrative -- to them anyway -- IPO business.
If you read only the middle column, which dealt with
using technology to spy on your kids at camp, then you
were passed on the right and the left by two disturbing
examples, in two different financing venues, of slipped
standards and booming issuance. The "Great Internet
Bubble" and the McMansion phenomenon might not
have been possible in the absence of these lowered
standards, which is why such lowered standards are so
popular.
Minsky's particular research interest was in the realm of
how finance affects economics. More than other
theorists, he saw them as inseparable, as two sides of
the same coin. His dark vision was that the cycles of
economic activity were accompanied by cyclical
behavior in finance, but that finance is not perfectly
reversible: You can't take the bank's money and build a
house and then change your mind and unbuild it in order
to return the bank's money. Like a game of musical
chairs, when cycles top out, there will almost surely be
some excess investment that cannot pay its way, and
so there will be loan losses. If those losses exceed the
reserves and capital of any financing institution, that
institution is in trouble. If there are enough such
institutions ... well, if the S&L crisis has faded from your
memory, just look at Japan today.
Spandex. The financial system is like a fabric, a
stretchy fabric that connects us all to each other in a
web of financing transactions that make the economic
world go round: His passbook savings account helps to
finance her line of credit. Decisions that each of us
make with regard to our own personal or business
balance sheets affect the way markets trade and the
economy performs. This financial fabric can stretch
almost grotesquely, like spandex (depending on who is
wearing it), enabling all sorts of economic activities to be
funded.
Those two Friday columns, played together on one front
page, pushed me to recall Minsky's concern that, like
spandex, the financial fabric sometimes snaps back. In
another reading that jumped out at me last week, a
Sanford Bernstein Research report titled "The Long
View" had this to say about the financial sector: "Bank
stocks are currently discounting growth that averages
only 3% annually and a number of companies are
discounting negative growth. Achieving these depressed
rates would require negative operating leverage and/or
much higher loan-loss levels than seem likely in the
near term. If the market is right, ROEs will also be
significantly compressed. The only period since World
War II that saw anything like this was 1985-91 when
banks suffered both from domestic commercial real
estate woes and from the first round of emerging
markets credit write-offs."
"If the market is right. ..." If Minsky is right. I need some
more uplifting reading matter. Maybe Harry Potter. |
