On the Other Hand

In my attempt to be taken seriously by the legion of economist-groupies out there, I just had to use the phrase that drove Harry Truman bonkers.

Having spent several recent posts on discussions of the similarities between the Greek/PIIGs sovereign debt issue and the subprime MBS issue of ’07 and ’08, I think it’s only fair that I give my readers a thin ray of hope that things won’t play out to an inevitable world wide collapse.

Since the web has induced a kind of one-click requirement for some researchers, here are the “anniversary” (both forgotten and lesson) and “contagion” posts that lead to today’s comment of the sort that made Truman wish economists were born with only one arm.

Big events vs. grains of sand

or, as economists might say

Lumpy vs. Granular

Now you know the difference between Greece defaulting, and thousands of subprime mortgage borrowers getting onto the foreclosure mill conveyor belt.

Unlike the situation where the attempt to stop the tide of mortgage defaults was ineffectively addressed by injecting capital into banks and robbing savers to give banks profits, a single bold stroke of money-printing may well stop the dominoes behind Greece from falling.

Can we declare victory and go home?

Nope.

Unfortunately, the last crisis created problems that affect the next one.  We broke it, so now we have to buy it.

What, exactly, did we break?

Glad you asked.

We broke the cheapest way to finance global commodities trade, a vehicle, by the way, that didn’t depend on the credit of financial institutions to work.  I know this is going to shock some of my “hard money” readers, but it was exactly because of the rejection of all things structured that global trade, especially commodities trade, is much more susceptible to bank problems than it was before.

As I explained in the chapter Contagion, the rush to call every portfolio or financing vehicle that had any subprime MBS exposure toxic waste destroyed the SIV and Asset-Backed Commercial Paper (ABCP) markets.

Some hard-money folks are saying “good riddance” right now, but the reality is that asset-backed finance had the deliciouslyAustrian (in an economic sense) quality of relying only on the value of the assets being shipped to retain its high credit rating.

For each global commodity, those two or three or five months on the high seas were mostly paid for by issuing Commercial Paper with an appropriate haircut (discount) so that when the wheat or iron ore (and yes, even gold ore) got to where it was going, it was still worth at least as much as the CP that had been issued.  I’m not saying there was widespread chaos in the prices being paid by the buyers, nor am I saying the sellers had to take their chances on market prices whenever they loaded up their goods for shipment.  What I’m saying is that sellers could get most of their agreed forward sale price as soon as they loaded up the bulk carrier ships and the buyers weren’t forced to pay for goods before they received them.  Neither party to the trade was forced to use extra capital.

So what replaced the ABCP programs that were doing such a fine job of financing world commodity trade at LIBOR plus a nickel?  Bank loans and lines of credit, or for some nationalized industries, sovereign guarantees.  I can hear the Austrians retching in the bushes already.

I can also hear the Keynesians saying “OMG, that must have increased friction and costs, inducing commodity inflation that had nothing to do with increased demand.”

Give the lucky winner a kewpie doll!

“Things” got more expensive, without becoming more useful.  Yecchhh!  That’s the opposite of gaining through efficiency.

To see just how bad forcing the global finance business into less efficient (and more expensive) forms like pure equity or suspect bank credit with high embedded costs, just take a look at the world economy in the eight years following the Oil Embargo of 1973.

The effect of higher fuel prices spread throughout the economy over time.  For example, I was selling industrial maintenance supplies at the time, and the most pernicious price increases weren’t even the ones in direct petrochemical products.  It was the job of telling paper towel and toilet tissue buyers about increases every month for more than a year that was the toughest part of that job.

To see how that worked, consider that paper involves heat to dry it, transportation fuel to haul around the precursors and finished products, and packing material (themselves made from paper), etc. etc.  In other words, the increases in various costs that had to be in the final price to the consumer were themselves driven directly or indirectly by oil prices, and those various costs showed up in the products with many different lag times that could take up to two years.

I suspect that effect is at work in most bulk commodities today, and that the injection of this financing cost induced inflation is not finished rippling through the commodities complex, much less the entire economy.

The other, far more pernicious form of contagion we saw in 2008 is not nearly as likely today as it was during the mortgage bond meltdown. (See, if you’ve hung in with me this far, there really is another hand to look at.)

In 2008, MBS bonds that any rational analyst would say were absolutely going to be paid in full were trading at very high yields.  Naturally, every other bond in the dollar bond universe had to match that yield, or get sold by smart portfolio managers who always choose higher yield with lower risk if they can get it.

That kind of contagion can’t be part of the next sovereign-debt spurred crisis unless the need for liquidity becomes so great that people start dumping Swiss Francs, global AAA bonds, and everything else.

I have a hard time seeing what the transmission mechanism could be for that kind of problem.  Certainly if Greece defaults and the CDS buyers/short sellers turn their guns on Spain or Italy, then we will likely see a number of banks stuck selling into a weak market and forced to raise capital through asset and/or new equity sales.  Before they get themselves recapitalized, each domino in the row would be traded as a weakened credit.  And, as I said before, we might find some super-strong credit wiped out because they wrote CDS on “good” banks or “strong” countries.  Yet again, the higher yields and lower prices for each link in that chain (or domino in the row, if you prefer) would be due to weakened credit.

To my mind, that is fundamentally different from an objectively strong credit (those “bullet proof” MBS) trading to a high yield, and forcing every other credit to match that yield or suffer selling pressure.

So take heart.  While we may see another meltdown and another global credit freeze, at least the process will have to be a bit different from the way it went down three years ago.

hh

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2 Responses to On the Other Hand

  1. Taymere says:

    Sub’ MBS currently offer 10% loss adjusted yield, not much lower than 2009 yields. It’s not that the “problem” can’t come back, it already has.

    • hhill51 says:

      The loss-adjusted yields ca. 2008/2009 were more like 20% or higher on ordinary private label paper. I’m talking about the stuff where most of the AAAs were already paid off, and the mezz and sub bonds were still there, giving the seniors 80% or higher subordination underneath them. You could run the numbers on those bonds with 100% immediate default and 10% to 20% recovery (7% to 13% LTV vs originations) and still get full paydown. That’s what I mean when I say “bullet proof”….

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