James Saft: Only way out is to inflate and default

Let Sleeping Shadow Banking Systems Lie

By James Saft
Reuters
Friday, March 6, 2009

http://blogs.reuters.com/great-debate/2009/03/06/let-sleeping-shadow-ban...

Rather than vainly trying to refloat the shadow banking system, the U.S. would be better off grappling with the inevitable ultimate solution -- debt destruction and inflation.

The common denominator of policies like the Term Asset-Backed Loan Facility (TALF) that was detailed on Tuesday, is that they try to solve fundamental problems with indebtedness by attempting to float asset prices high enough that they are back in proportion with the debt.

Even more, they use the same structures that worked out so poorly -- highly levered hedge fund like vehicles and securitisation -- but this time substitute government funding and leaves the taxpayer as main bag-holder if the deals go bad.

With up to $1 trillion, the TALF is designed to restart parts of the securitization market such as auto, business and student loans. This followed the plan to avoid foreclosures and further house price falls by cutting borrowers, many of whom made silly borrowing decisions, a break on their interest rates.

Next up: a public-private plan to buy up toxic legacy assets from banks, which should be detailed in the next two weeks. Again, that program will provide government money at sub-market rates to investors to entice them to pay more than the market price for assets that would otherwise sink many banks.

The higher the leverage supplied the higher the price hedge funds and other investors will pay for doubtful assets. After all, like a Florida condo flipper, if the asset declines in value they can just walk away and throw the metaphorical keys at the Federal Reserve and U.S. Treasury.

"We want to make sure that the prices of the assets that are purchased reflect true market values that are not overpaid. So the idea between the public-private partnership would be that there would be both public and private money involved and that the pricing decisions would be made by private-sector specialists, not by public bureaucrats," Fed Chairman Ben Bernanke told Congress on Tuesday.

"If the government is willing to provide longer-term lending, or leverage, there are many investors who presumably would be willing to buy under those circumstances who are unwilling to buy without the credit, without the lending they need to finance those purchases."

I simply cannot reconcile the first part of that statement with the second. What do we mean by "market values" in a situation where the government provides financing not otherwise available? Vary the leverage and achieve any price you like.

... Living in a cash-flow world

The TALF is slightly more defensible. There is a market failure when reasonably good credits can't raise money under any circumstances. But before we try to restart securitization and the shadow banking system, let's recall what the problems were in the first place. For one thing the TALF relies upon imprimaturs from the credit ratings agencies which have been found wanting. That's not yet changed, but government participation simply papers it over.

Even the obsession with banks almost seems beside the point.

"You won't revive the economy through debt," said Albert Edwards, global strategist in London at Societe Generale.

"Banks aren't the problem. They are a symptom of the problem."

The problem is that asset prices are out of line with their ability to generate cash flow. Falling prices do impose a risk premium but the real issue, for stocks or for houses, is that their prices are not in the proper proportion to the debts they carry and to their ability to generate cash. That happened in part because of the shadow banking system and was a mistake.

So what's the implication? Some debt will be repaid but a lot will just be destroyed via default. An organized writedown seems impossible. That will be a huge problem for the banking system and the country, and you can understand why the government does not wish to meet it head-on.

University of Oregon economics professor Tim Duy thinks the U.S. will ultimately end its romance with financial engineering and get down to working through unsupportable debt the old-fashioned way -- inflation.

"And therein lies the key to predicting when the Fed shifts gears: when Bernanke abandons the notion that proper credit market functioning is alone sufficient to restore housing values (asset values more generally) to their former glory and support acceptable growth," Duy writes.

"At that point, the Fed will again consider the wisdom of what it has defined as quantitative easing, an expansion of the balance sheet via a deliberate expansion of liabilities."

That is a dangerous and difficult-to-govern process, and the U.S. shows every sign of being willing to pay a very high price to avoid it.

But ultimately the price will be too great and we will have to inflate and default in some mixture.

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James Saft is a columnist for Reuters.

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