TCS Daily


Never Sell America short

By Larry Kudlow - September 23, 2008 12:00 AM

We can fix this. If nothing else, that's the message I hope readers take away from this column. Of course, the "this" is the run on the world banking system. Stock markets have plunged globally, gold prices have shot up, and U.S. Treasury-bill rates have plummeted to 10 basis points, the lowest since the 1950s.

We're witnessing a desperate flight to safety by investors. Folks are running away from financial assets and financial institutions simply because confidence has disappeared.

This week, Treasury secretary Hank Paulson said "no" to a government bailout of Lehman. Paulson and Ben Bernanke then took over AIG with an $85 billion bailout, with the Treasury issuing roughly $100 billion in new T-bills so the Fed has the cash to resuscitate AIG.

All this was necessary. A collapse of AIG would have been unfathomable -- it is simply too interconnected globally. But it turns out this rescue mission only elevated investor fears. Shareholders are asking: "Who's next?"

The bears are now raiding Morgan Stanley and Goldman Sachs, two national treasures. Meanwhile, the Reserve Fund -- an original money-market fund launched by Bruce Bent, a hard-nosed friend of mine who for decades has supported conservative political causes -- has seen its net asset value drop from $1 to $0.97. That's a shocker. And the reason? The fund's holdings of Lehman commercial paper were unsupported by letters of credit.

Money-market funds are supposed to be safe havens for mom and pop -- for Mary and Joe in McKeesport, PA. But everybody now wants T-bills and gold.

Well, it's time for some perspective. The world is not coming to an end. The stock market has tumbled, but it's still over 10,000. In late 2002 it was 7,500 and in mid-1982 it was 750. Are things really that bad?

With home prices falling, foreclosures and defaults are at the root cause of the run against all manner of mortgage-related bonds held by the banks. But as investment guru Don Luskin points out, foreclosures today are less than 3 percent. During the 1930s they were 50 percent. Or how about the unemployment rate? Today it's 6.1 percent. Back in 1982 it was near 11 percent and for most of the 1930s it was over 20 percent.

As the oil bubble pops the underlying inflation rate is somewhere between 2 and 3 percent -- quite unlike the double-digit hyperinflation of the 1970s. Home prices themselves have fallen between 10 and 20 percent, but they're still about 50 percent higher than at the start of the decade.

And there are constructive policy measures that can help fix the market's problems.

Investor Zachary Karabell writes persuasively in the Wall Street Journal that "mark-to-market accounting in the aftermath of the Enron scandal makes no sense at all." Many banks have taken huge losses on mortgage-backed securities and their derivatives because the SEC insists on mark-to-market. But Karabell asks: Why knock down these bond values, sometimes by as much as 100 percent, when the underlying home values embedded in the mortgages have only dropped 10 to 20 percent? And in the long run, the housing market will recover, as it always does.

Bad accounting rules like this are sinking the financial system. And why hasn't the SEC restored the up-tick rule to stem cascading share-price declines triggered by manic short-sellers? Short-sellers are an important part of the stock market, and they add liquidity at crucial junctures. But until July 2007, they could only short a stock after the share price rose, not while it was continuing to decline. The SEC also should restore the net-capital rule, which limits banks to a 12-to-1 leverage ratio governing their debt. Over-borrowing by Wall Street is what got many firms into deep trouble.

A gathering consensus also seems to be forming around a new version of the Resolution Trust Corporation, which effectively disposed of bad savings-and-loan assets in the early 1990s. A new RTC could purchase underwater assets that proliferate through the financial system and are clogging the credit and loan arteries of our banks.

We clearly are in an emergency moment. But the government should opt for smart regulatory action rather than broad-based interference that could stifle the free economy. On Thursday afternoon, as rumors spread that Paulson was talking President Bush into a new RTC, the stock market soared 400 points. That's what I call an endorsement.

The pessimists are now talking about the end of capitalism or a permanent decline of America. I don't believe that for one moment. Specific regulatory reforms can get us out of this fix. And most of all, policymakers must maintain the low-tax, low-inflation, open-trade formula that has propelled this nation's economy and produced so much prosperity for so long.

I say, never sell America short.

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12 Comments

AC coupled
An alternating current (AC) electrical circuit only responds to change.
Humans tend to be AC coupled.
This I suspect is a wonderful evolutionary trait which allows us to get used to just about any horrible (or wonderful) situation we find ourselves in.
Humans adapted to concentration camps in Germany and POW camps in Hanoi. They also adapt to peace and prosperity.
People adapted to 20% mortgage rates in the '70s, but whine now when they rise from 5.5% to 6.0%.
Responsible journalists and politicians should have a sense of perspective. Those that don't are trying to 'sell' something, like Al Gore and AGW.

Mark to Market
It does seem that one thing a new-RTC could do is buy the mortgage securities at a price based on value to maturity with a reasonable reserve against default possibility. In other words, maybe the bail out proposal is simply a way around the problems caused by an overly cautious mark to market requirement.

Its just like in Kill Bill, Part 1...
...we are the Uma Thurmans in a coma. The government is named 'Buck' and his crony buddies are the dudes passing around the Vasilube(tm) jar.

"Hi! My name is Buck! And I like to f...ix Wall Street!"

When you are irresponcable, you need to be
corrected and restrained.

When I trust my 10 year old to get dressed, and ride the bus to school, then he misses the bus, I watch him the next day until he does it right.

These inverters where given freedom and they abused it. They need over site. They have already proved that they are unable to control them selves, so them must be controlled.

If you let others take the place of those who failed they will fail to... Its just human nature. People are greedy and stupid. They need over site, they are taking advantage of the publics money.

Just as there are no atheists in foxholes...
..there are also no libertarians during a financial crisis.

T-bills
What a difference a week makes. Back on Sept. 23, Kudlow writes "..everybody now wants T-bills and gold."

Today it's the 28th, and Congress has just approved the fresh $700 billion expense. Does this mean the taxpayers will have to come up with the money? No, not exactly.

Since we're already operating at over nine trillion in the red, what'll happen is that we'll have to offer these 700 big-uns in the next Treasury auction. And then we'll see how badly the world bond market wants to pick up these turkeys for its portfolio.

Interest rates will be going up fast. And that will have repercussions for the federal budget, since we're already paying over $400 billion a year in interest on our existing obligations-- at rock bottom rates. I wonder what that will be when we have to start paying back in something like REAL money.

Here's the Plan
All those defective mortgage-backed securities did have a market value. It was just not one the holders were willing to trade for. Buyers were typically bidding twenty to forty cents on the dollar, while the debt owners were holding out for sixty to eighty cents.

What should have happened was the federal government buying the shoddy goods up at fifty cents. Then they would just have become another investor. They could have renegotiated all the troubled loans and kept the homeowners in place-- continuing to pay about what they had been paying before their rates reset. So a goodly part of the seven hundred billion "bailout" cost would have continued earning income and retaining value. It wouldn't actually have been that much of a bailout, but more of a cautious investment. And at fifty cents, not such an expensive one.

Instead, we appear to have gotten the worst of outcomes. Some part of the bailout money is going toward the government's acting as a new insuror for the old debt holders, rewarding them with backup for their stupid behavior. This is a case study in reinforcing moral hazard.

Furthermore, all it does is to enable the privatisation of gain, while socializing the downside risk. It's a "free market" Republican's wet dream.

Ok everybody! You read it here (er, in the above) Roy predicts..
..that our foreign creditors will finally say 'no' and interest rates will spike as a result.

Roy - Expect me to reference that thread entry (which will be proven wrong) for like, umm...FOREVER..whenever you make any more 'brilliant' economic predictions, ok? Fair warning.

Sounds like a bet
Fair enough. When's the next auction, October 13?

US investors will certainly retreat to T-notes, as they're accustomed to thinking in dollars. But will they be buying up the entire offering, $700 billion? Not if it's all dumped on the market in a single pile, they aren't.

And overseas, I'm thinking this may be the straw that will break the dollar's back. It takes a dull-witted investor to continue putting his cash into a product being extruded from a runaway printing press. The retreat from the dollar will be picking up steam... and there isn't enough gold in the world for every nation to put their savings there.

At a typical 2-4% return, T-bills are a sure money loser. At the actual inflation rate (not the official rate) the dollar's losing something around 5% a year now, and getting ready to slide a lot further. Is that really the best rate the central banks of the world can find to house their profits? They're going to be looking for a better ROI. At least I would.

We will see.

atheists and libertarians
I am still a libertarian.

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