Enduring Credit Crunch
The FDIC just released its periodic list of financially troubled banks. There are 117 listed banks, up from 90 last quarter, commanding $78 billion in assets, up from $26 billion. FDIC leaders say the report is unsurprising, noting that the credit crunch that began more than a year ago does not appear to be abating.
At least two profound problems contribute to the enduring credit crunch, of length and severity not seen since the Great Depression. The first is that the securities driving the crunch, including pools of sub-prime mortgage loans with complex features, are difficult to value. Investors continue to shun them. The second is that the US government’s efforts at building confidence despite those valuation difficulties have failed. Investors are not impressed with the government’s actions or plans to date. No solution to either problem appears on the horizon.
Fed Chairman Ben Bernanke quipped last October that a central challenge facing the credit markets concerns whether anyone knows how to value the complex securities formed by pooling various tranches of sub-prime mortgage loans and other assets. The Chairman received no answer to his question and reliable valuation models for many of these instruments remain elusive. Today, some observers say that many of the securities are underpriced, given probable cash flow losses. This view holds that potential investors are unduly pessimistic and are insisting on an unjustifiably, irrationality-induced liquidity premium. Others observe that, enduring credit market skittishness may yet spread or deepen, threatening a global recession. Investors may rightly lack confidence the securities are being offered at attractive prices.
Either way, investors are not lining up to buy these securities. Even speculatively inclined buyers, from arbitrageurs to bottom fishers, do not appear eager to own this paper. They may not think the market’s bottom is here or perhaps even near. Don’t expect value investors to budge either. These investors seek opportunities to buy securities at prices below value and could find some of this paper appealing at the right prices. But value investors insist on having reliable information supporting the existence of a price-value spread sufficient to give a margin of safety. It is a demanding standard. This may explain why potential buyers, such as Warren Buffett, remain on the sidelines.
What may change current investor thinking? Governmental confidence building does not appear to have worked thus far and new ideas appear to be scarce. Reports from the Federal Reserve’s (Kansas City) annual finance symposium this weekend are suggestive. Few new practical ideas to resolve the immediate crunch emerged. One that reportedly enjoys renewed interest is a slightly modified version of an aborted proposal floated by Treasury Secretary Hank Paulsen last October. The earlier proposal, which I discussed here , imagined having existing holders of the paper, especially large banks, hive off higher quality slices of these assets into a special purpose conduit.
The conduit offers securities to investors backed by this paper and uses the proceeds to buy the paper. This removes it from the banks’ balance sheets, enabling the banks’ to terminate any related positions used to fund it and reduce the magnitude of associated write-downs for losses on the paper. The aborted plan did not draw requisite investor interest. A principal change in the new plan, designed to induce investor interest, may be explicit government guarantees to investors concerning negotiated aspects of the paper’s risks.
To date, however, similar governmental guarantees and assurances to investors and credit markets have not worked. The most prominent example concerns expanded statutory authority allowing the US Treasury Department to provide an open-ended variety of guarantees, capital infusions, or outright equity acquisition of Fannie Mae and Freddie Mac, cornerstones of the US mortgage market. But, so far, investors have not responded favorably to this government support mechanism. Shares of the two companies continued to slide and remain stagnant in the single digits.
Beyond current difficulties, the Treasury and Congress’s experimental approach to supporting Freddie Mac and Fannie Mae have implications for broader reform ideas the Treasury is offering. In its March 2008 blueprint for financial regulation reform, Treasury proposes expanding federal power to support a wider array of financial institutions than historically. This means offering liquidity to investment banking firms and other financial institutions well beyond the central bank’s traditional support for depository institutions. Treasury’s hypothesis is that, if this power is in place, the comfort that it provides the marketplace, including investors, will make its exercise unnecessary. The pending fate of Fannie and Freddie is testing that that hypothesis, and the prognosis is not promising.
So it is possible that the battered securities cannot be moved, by sale, trade, government buy out or otherwise. Current owners, mainly large banks but also regional ones and other financial institutions, including those appearing on the FDIC’s list of problem banks, may face continuing write downs for an extended period of time. The year-old credit crunch may yet be young.