"The uncertainty regime
- Posted by:
- Economist.com | NEW YORK
- Financial markets
WHEN uncertainty reigns, consumers turn into savers, investors stop investing, and the economy grinds to a standstill. Uncertainty is rampant in many parts of the economy—how much lower will the Dow fall? How high will unemployment rise, and what jobs will never come back? And weighing most heavily on investors' minds, what in heaven’s name is the government going to do about it?
Amity Shlaes has made the contentious argument that the Great Depression was as long and painful as it was because of the uncertainty surrounding government policy. Such uncertainty certainly exists today and is not helping us to get out of this crisis. For instance, the financial sector will never recover as long as the fate of financial institution debtholders remains unclear. Because no one wants to lend to an even marginally troubled bank in this case, their liquidity problems become more severe, and we can forget about banks making new loans.
Another source of uncertainty is the value of toxic securities clogging up bank balance sheets. Banks holding these securities claim they don’t know if they are insolvent because it’s impossible to price those assets (or they just don’t want to accept the value the market currently assigns to them). The government cannot simply buy and remove them from balance sheets because no one knows how to price them at a point where banks are willing to sell and where taxpayers won't be ripped off. The first instinct of policymakers has been to somehow get rid of these assets and section them off into a bad bank, possibly owned by the government. But it's still unclear on how this will be done and what these assets are really worth.
I recently spoke with a quant whose job is pricing and selling mortgage-backed securities. I was surprised to hear how busy he has been; who is selling these things and buying them? He claimed the recent Moody’s downgrade meant that many institutional investors had to unload the securities off their books (due to provisions that nothing in their portfolio can be less than a particular investment grade) and realise the loss. The quant claimed some hedge funds are snapping them up as the influx of the securities on the market is bringing prices down even further. Still, bid ask spreads have been as large as 15%.
At the rate these securities are trading now (often less than 30 cents on the dollar), he claims that all the underlying mortgages could default and you could still make money on the security. So, other than liquidity issues, why isn't everyone buying them? If prices are such that the securities will make a profit even with universal default, shouldn’t the market clear and we finally have a price on these things?
He claims the assumption of profitability is based on current conditions—even if you buy a mortgage-backed security for 20 cents on the dollar, you still can't put a lower bound on its potential value because the probability of government intervention is high and what government might do can't be forecasted. Until the government has a credible housing policy, no one will be able to assign a certain value to mortgage-backed securities. The housing market will also not bottom out on its own, because even with the current plan, no one is sure what the government will do.The current administration claims it understands how important credible, consistent, and clear policy is in relation to the housing market and the financial sector. But has not been providing that, probably because with so much uncertainty around it does not want to risk having to change course as things unfold. But leaving markets in the lurch just prolongs the pain."
Don the libertarian Democrat wrote: