The End of the Risk Free Asset

However the debate of over the extension of the U.S. government's debt ceiling plays out, this episode marks the beginning of the end of the risk-free asset. What that will mean for financial models, economic policy, asset-liability management, investment strategy and so on is anybody's guess. But the mere circumstance that the federal government is entertaining the possibility of default as a result of political exigencies challenges forever the assumption that U.S. dollar denominated short-term U.S. Treasury obligations can serve as a risk-free benchmark.

Observers as a group have been so fixed on the recent commonplace circumstance of sovereign default--the inabilility of the borrower to service debt denominated in foreign currencies--that the rather more difficult context of a borrower electing to default despite its ability to meet its obligations or defaulting for other (overwhelming) reasons has been overlooked. In other words, everyone has been endlessly focused on the example of Argentina within the last decade rather than Ecuador. Or on Russia 1998 rather than Russia 1917.

The apparatus is in place for handicapping, assessing and evaluating sovereign defaults of the first type. One can argue that inflation is a form of default for sovereign credits capable of borrowing in their own currencies, and inflation is a topic that has been beaten to death. The machinery for dealing with those credits that have borrowed in dollars may be controversial, but the drill is commonly understood. It even translates into Euroland.

The second type of sovereign default, though, is a horse of a different color. In the paradigm Stephen Roach used to employ (pre-2008), the sources are exogenous rather than endogenous. More colorfully, if the politicians are unwilling to pay a government's debts, it matters little whether they came to power through a Tea Party, rolled in with an invader's tanks, or led a revolution that involved standing the ministers of the prior government against a wall and shooting them.

Obviously, no one knows what the result of this astonishing display of financial irresponsibility will be. I am not going to hazard a detailed guess. In the short term, probably not the end of the world. Probably not a non-event. Probably a recession, that may have been coming anyway. A Washington Recession of 2011 to go with the Wall Street Recession of 2008. Probably a great deal of short term confusion, disruption and hardship. If culpability for causing this situation clearly lies with the Republicans in the House, the responsibility for how the disruption is handled with clearly lie with the Democrats in the Administration.

Longer term, it is hard to say what it will do to interest rates. No one can predict the term structure, level, or credit spreads of interest rates in a world without a risk-free benchmark. I suppose the value of financial assets across the board should diminish dramatically, but whether that happens quickly or slowly is anyone's guess.

It will be bad for the dollar. It opens a window for the Germans to lead the Euro into a new role. But it's astonishing how little interest a country that started two world wars using its military machine to conquer Europe has so little interest in doing so using the economic and financial muscle. That calculus may be recomputed. Unless all the Germans are on vacation for August, in which case that can wait until autumn.

All the smart money has been betting on a collapse of the Euro because of its conceptual flaw--a common currency without a common political system. But given the performance of the American political system this summer, perhaps that's not the defect it seemed to be. A unitary political system without a common agreement to honor its full faith and credit financial obligations doesn't assure very much. Certainly not enough for U.S. Treasuries to serve as the 'risk-free' asset of the global financial system.

So, get ready for a brave new world . . .

The Time o'the Jarmins--The Irish Should Default Spectacularly

In 1916 the Easter Rising Failed.

Men were hanged.

Casemate came home to face the music and he was hanged. Ah, those Black Diaries.

He was in Jarmany tryin' to arrange for the u-boats to deliver a load of weapons to support the Patriots. The Jarmins, the u-boat, the weapons, never arrived.

Same thing happened in the Year of the French. 1798, I think it was.

I dunna know how stupid the Irish are, but if they can't, once every hunnert years, stand up and die, they're stupider than the good Lord himself can save.

Mind you, I'm not talking about knee capping and the religious stuff.

Foreclosure, Fiasco and Frolic with MERS

A week blessedly silent on the 'fraudclosure' front came to an end yesterday when the decline in pending sales for existing homes was attributed by the National Association of Realtors spokesperson to the bottleneck in the foreclosure pipeline. To hit the refresh button, here is a Q and A, supplemented with some judgment calls:

1. Will MERS work? MERS is the electronic recording system used by the 'industry' in lieu of compliance with recording requirements that vary by the jurisdiction in which the secured property is located. First, for some purposes MERS was such a success that it was extended from residential to commercial properties, so in some sense MERS works. But the question that has everyone excited is:will MERS work when the rubber hits the road in a foreclosure?

The answer to that is--MERS should work some of the time for some purposes, but it almost certainly won't work all of the time, and there is an unacceptable degree of uncertainty surrounding how it will play out. When it doesn't work, it should be fairly easy to fix, assuming the backup documentation is in order.

2. What's wrong with MERS? There is an effort being made to portray the problem as simply one of paperwork lapses and antiquated local filing requirements. It actually runs deeper than that. There is a conceptual (and constitutional) limitation on judicial power--courts only decide cases and controversies in disputes brought to them by litigants. Courts do not go shopping for opportunities to flex judicial muscle (unlike, say, a police force, that should chase criminals rather than simply waiting for them). To bring a lawsuit, the prospective litigant must be a 'real party in interest.' A real party in interest is someone with a injury or other legally recognisable stake in the outcome of the controversy. In a nutshell, MERS more closely resembles a custodian or a registrar, who wouldn't be a real party in interest, than a trustee or a beneficial owner, who could be. To put it in lay terms, if you have a warranty issue with your car, the owner of the garage where you park it can't sue the car maker for you, you have to do something about it yourself.

The good news is that it's not generally that hard to figure out who should be bringing the lawsuit, again, assuming the backup documentation is in order.

3. That's the second time you've qualified an answer with that comment about backup documentation. What gives? Over the last several decades a complex and standardized process has developed in which home loans were made, mortgages originated, warehoused, deposited in trusts and used as backing for the issuance by the trusts of 'mortgage backed' securities. Then, until the loan was refinanced or otherwise paid off, a 'mortgage servicer' collected monthly payments, distributed the proceeds to the securities owners and handled any administrative or similar issues that came up (for instance, usually made sure that property insurance and taxes were paid). That was how the system was supposed to work.

It has recently come to light that in many instances chunks of this work, mostly in the middle of the chain, simply weren't done. In other words, at the front end the house closing came off without a hitch. At the back end, the MBS were issued and sold without a hitch. But, the transfers in the middle--the movement of the note and the mortgage through the conduit of bankruptcy remote vehicles--didn't happen, for whatever reason.

There are also allegations that in some jurisdictions the loan documentation was routinely destroyed. (Gretchen Morgenstern recently made this claim in a New York Times article about the situation in Florida). If true, this is mindboggling, since the legal genome is deeply imprinted with the bedrock belief that certain kinds of promises, to be legally enforceable, have to be in writing. There is something called the Statute of Frauds, dating back to the English common law, not only before the American Revolution, but before the colonization of North America. We inherited it, it runs through our legal system the same way trial by jury does. It's common sense, really. There are two kinds of promises. One, is, for example, "I'll never forget our anniversary." The other is, for example, "from even date herewith, borrower promises to pay lender $857.62 on the fifth day of each month until August 5, 2035." The latter you can sue on in court, good luck with the former.

If there are widespread documentation problems of this sort, regulators of the financial institutions responsible for those back office failures will face a challenge to their supervisory authority concerning, not the liquidity and solvency of the responsible institutions, but the adequacy and soundness of their managements, systems and controls. It may be enough to sink a couple of boats.

4. But assuming the backup documentation is there, the MERS issue can be fixed easily?

Easily may be an overstatement. Let's qualify it with three considerations: (1) economies of scale, (2) the example of bankrupt originators, and (3) the question of who owned what, when?

Economies of scale. This is a high volume process. We are talking assembly line justice, not a handcrafted approach tailored to each borrower's unique circumstances. A lawyer's rule of thumb is that it costs three times as much to fix a problem as it costs to do it right the first time. And keep in mind, it is totally appropriate for the borrower (or her lawyer) to object to any shortcut or impropriety. If the shoe was on the other foot, you can be sure the bank and its lawyer would be.

Unfortunately for the servicers and the MBS holders, I don't think these fixes are going to lend themselves to economies of scale. It will cost as much to correct the documentation on a $100,000 mortgage as on a $300,000 one. There may be more walkaways at the low end and more contested proceedings at the high end, but that is not so much an opportunity for economies of scale as a recognition of additional unpredictable cost in certain circumstances.

One area worth paying particular attention to is commercial real estate. In the bankruptcies and workouts of various failed commercial development projects, it's reasonable to expect all the MERS issues to be litigated completely and expensively. That will litigation among creditors--there won't be any homeowner victim/deadbeats in that arena. Those stakes are worth litigations. And that's an arena in which technical deficiencies in documentation (such as failure to timely perfect a security interest) tend to be penalized severely, to the benefit of the competing creditor/vultures.

Bankrupt originators. The outfits that originators mortgages weren't the most stable financial institutions. A number of them have gone belly up and are in their own bankruptcy proceedings. If, because of 'paperwork deficiencies' there are pools of assets potentially available to the creditors in those proceedings, those claims will be made. The problem has nothing to do with homeowners and mortgage servicing outfits. But you can bet it will gum up the works.

And it offers a good example of the simple fact that in this situation everyone is not going to pull together. The situation is rife with conflicting interests (and internal conflicts of interest). There is not much point to ascribing evil motives to litigants (or their lawyers) in civil proceedings, though it is certainly common.

Who owns what, when? The big issues in a foreclosure are getting the property back, of course. But there are also issues of past due amounts and servicer fees. Taking care of the MERS problem does not address the question of who is owed what, how the proceeds from the sale of the foreclosed property are distributed, what is the fate of any second lien holders, whether there will be a deficiency judgment, etc., etc. On one level, these issues are technical. But they are also disputable. It's a safe guess that they will be disputed.

5. Does resolving the procedural questions involving MERS solve the whole problem?

No, it doesn't even begin to. It's a good first step, but no, no, no . . .

Earthquake?

We've shifted from Change You Can Believe in to change you can't believe in. And that's the transition from Obamanos to the Tea Partiers. Party like it's 1773, I guess.

This is the third consecutive election in which the American electorate has collectively asserted a more or less coherent opinion. In each case, it boiled down to 'throw the bums out.' So far, nothing of the sort has happened. In 2006 with the Republican losses, in a parliamentary system a new government would have been formed. In 2008, with the sweeping Democratic victory, a new government with an ability to implement new policies would have been installed.

Does anyone seriously think that control of the House will give the Republicans the ability to do anything more than formally, finally and completely stalemate the Democrats in control of the Senate and the Presidency? That, and perhaps shut down the government. That, and utterly preclude effect action at the national level on any of the issues concerning the economy.

This country is starting to look like a richer version of China (or maybe Mexico back in the days of the PRI). With a better human rights record, in either case.

Postscript.

Mrs. Sarah Palin, the former governor of Alaska, announced the results of the midterm elections with a video of a roaring grizzly bear, forepaws waving in the air, alluding to her 'mama grizzly' theme. Elsewhere, in the People's Republic of China, the Party announced the results of the 2012 presidential succession with the appointment of Mr. Xi Jinping to the Central Military Commission. While Sarah Palin has expressed a taste for grizzly bears, Xi Jingping has expressed a distaste for overfed foreigners with nothing better to do than criticize China.

Home and Away

Consider a country in another time and space. It is big and sprawling. It is too big and and too sprawling to be governed by a cadre, ruling class or oligarchy. It is a veritable nation-state of quasi-continental dimensions. In form it is a representative government, somewhere between a people's republic and a constitutional monarchy. But its political processes are as captured and as ossified as one might expect of an ancient, honored and imperial republic. Not a single party state by any means, but two parties jointly rule in a comfortable though occasionally unruly duopoly. This country still imagines itself as a Beacon on a Hill.

As might be expected, it has a political class and a financial elite. They are not exactly open, and not exactly closed. Porous is perhaps the best way to think of them. And much of the rest of the place is not particularly interested in joining either. There is also a cultural elite (several, in fact), various underclasses of varying hue and diverse origins, and all the complications and ramifications of several centuries of development as a civilization (all the while trying to imagine itself as a source of innovation and progress). For whatever reason, that bit is critical to its identity.

A few years ago, an economic crisis developed, mostly as a result of internal contradictions in organization, but in the aftermath of a some fairly miserable foreign adventures. And the situation had enough external aspects that it is possible, as most peoples are want to do, to blame the rest of the world for the current difficulties. As a result these people find themselves is a slow and tedious recovery without the instant return to happy prosperity that they believe is their due as the world's Beacon on a Hill and source of innovation and progress. That has soured the politics and the economy, and made them a bit more unruly, but so far had no greater ramifications.

In the throes of the economic crisis, that financial elite successfully held the political class hostage with a threat that boiled down, according to a domestic humorist, to 'save our banks or we'll kill your economy.' A reasonable number of the banks were saved, and since then the government has papered over (literally, printing gobs of the stuff) the inability of the banking systems to meet broad swaths of the mandate its social contract implies. In the process, interestingly, various agencies of the government have developed a set of procedures, capacities and competencies that significantly reduce the necessity for a financial services sector as presently constructed. But that has occurred almost by stealth, with virtually no public comment.

In the aftermath of the crisis, the political class was collectively enraged by the failure of the financial elite that it had just saved to 'stay bought.' This is entirely understandable. As a group the political class is premised on relationships rather than transactions. Relationships come in all varieties and strengths, but they are generally characterized by concepts of power, obligation, and nuanced flexibility through time. As a group, the financial elite is oriented towards transactions. Transactions come in equal variety, but they are generally one-off, creating no long term obligations, and the terms are set at the outset, lived up to, then renegotiated (or confirmed) before the next piece of business is done.

From the point of view of the financial elite, the political class were suckers. They didn't extract enough advantage at the outset of the transaction and so they sold their assistance too cheaply. To come back afterwards and expect to recut the deal is naive beyond words. Once past the crisis, the sensible thing to do, for the financial elite, was address the urgent rebuilding of their wealth--both at the institutional and the personal level. The public optics of that exercise would be manageable.

Fairness compels a distant observer to note that the first match of this series was fought in the home court of the financial elite. The political class was operating on the turf of the financial elite, for high stakes. The early innings moved at a fast moving pace, without time or space for reflection, compromise or error. When in its latter stages the political class attempted to collect for its assistance, it got stiffed (so did the public interest, but only a fool would expect optimal policy outcomes in a game played by these rules).

And there will be a rematch. It may come fairly soon. But it will not play out quickly. It will not play out on the home turf of the financial barons. It may not play out in public. And the result is not foreordained.

I have the sense that the opening volleys are being fired in this whole mortgage fiasco. The early efforts to quantify the impact are fairly amusing. We haven't even figured out how to characterize what's been going on. Is it a paperwork snafu caused by antiquated real estate filing requirements under state law? Is it the commission on an almost heroic scale of routine criminal acts of forgery and perjury for which bank charters should be surrendered and senior executives imprisoned. Is it a systems breakdown that with the commitment of organizational resources on a massive scale can be remediated. Is it the sort of back office failure of epic proportions that delivered the final blow to so many Wall Street brokerages of the Go-Go Years and required a regulatory reshaping of that landscape?

So damage assessment is way premature. How this plays not only will depend on what needs to happen to fix the problem that first brought it to light. It will depend on a variety of other agendas: internal agendas, public agendas, regulatory agendas, private agendas. And the battle lines aren't drawn yet, the roles haven't been defined. Look at the New York Fed--it is a regulator, customer, agent, plaintiff, etc., etc.

And just because the financiers won their home game, that doesn't give them any advantage when they play away. If the way they've run their operations in the past is any sign, Big D has never been a strong point on their side. And that's what will be needed. Nor have cohesion, class solidarity or anything else along the lines of cooperative, collective, united front activities been strong points. Their leadership are the alpha fish of a shark tank--cold, slimy, powerful, dangerous and stupid.

Furthermore, on the basis of their behavior since the crash, I think it is more likely that they will be hooked, netted and filleted. But time--lots of it--will tell.

Throwing in the Towel

Is this the beginning of the end,
for our old friend,
extend and pretend?

At least as far as the commercial and residential real estate markets and the continued viability of the financial services sector as presently constituted are concerned?

Consider the following seven data points/factoids/developments:

1. Over the summer the first time home buyer incentive program came to an end. There is no political appetite for resuming it.

2. All of the housing indexes are indicating a resumption in house price declines. Good news for home buyers, bad news for home owners and lenders.

3. Residential and commercial construction is dead. Still dead. Not yet undead. Making no contribution to the 'recovery,' such as the recovery is.

4. HAMP was a failure. And servicer footdragging/non-cooperation that contributed to that preceded the inevitable homeowner redefaults to come.

5. There is the nasty little problem of a huge slug of not-yet-written down second mortgage loans on the books of various TBTF financial institutions (arguably a reason for the footdragging mentioned in point 4?).

6. The commercial real estate market, which hasn't been supported with the kind of governmental effort that has distorted the residential market, has resumed its decline and continues to set new lows. A contributor to continuing weakness of bank balance sheets and a harbinger of the residential real estate market?

7. The foreclosure gate scandal is leading all kinds of revelations about how the originate-to-distribute business model has actually been functioning (perhaps since inception?).

And a bonus, freebie, consideration--18 months ago the feds required the major banks to prepare stress tests predicated on a pair of assumptions concerning the path of residential real estate prices and unemployment levels. House prices could drop slightly more than 15% from where they are today without dropping to the the price levels projected in that exercise for the base case. House prices would have to drop almost 25% before reaching the levels projected in the more adverse case for the stress tests.

All of this suggests that a strategy of 'let's just hold things together 'til things get better' may have exhausted its utility and that the the time may have come to actually address the problems.

G20 Meeting and the Lessons of Japan

The truth that was illuminated at the G20 meeting.

If you assess currency manipulation by the impact of policy on exchange rates rather than the announced intentions of policymakers, we are all manipulating our exchange rates.

Er, so let's change the paradigm?

The Lesson of Japanese Lost Decade.

In a world of globalized trade and free international capital flows, the effects of a Keynesian approach to economic stimulus at the nation state level will dissipate across the globe and cannot be effectively targeted within the geographical boundaries of a national economy actively participating in the international trade (probably either as an exporter or an importer). You simply turn your currency into a funding vehicle for the carry trade.

Anyone care to speculate in the emerging markets using the dollar as a funding currency?