[NYTr] Govt. should rescue overindebted homeowners directly

[All the News That Doesn't Fit]

Pacific Income Management via GATA - Aug 26, 2007
http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2007/IO+September+2007.htm


Where's Waldo? Where's W?

Govt. should rescue overindebted homeowners directly

By Bill Gross 
Pacific Income Management Co.

During times of market turmoil it helps to simplify and get basic
-- explain things to a public and even yourself in terms of what
can be easily understood.

Goodness knows it's not a piece of cake for anyone over 40 these
days to understand the maze of financial structures that now appear
to be unwinding. They were created by youthful financial engineers
trained to exploit cheap money and leverage who showed no fear and
who have, until the last few weeks, never known the sting of the
market's lash. They are wizards of complexity. I, however, having
just turned 63, am a professor of simplicity.

So forgive my perhaps unsophisticated explanation to follow of how
the subprime crisis crossed the borders of mortgage finance to
swiftly infect global capital markets. What Citigroup's Chuck Prince,
the Fed's Ben Bernanke, Treasury Secretary Hank Paulson, and a host
of other sophisticates should have known is that the bond and stock
market problem is the same one puzzle players confront during a
game of "Where's Waldo?" -- Waldo in this case being the bad loans
and defaulting subprime paper of the U.S. mortgage market.

While market analysts can guesstimate how many Waldos might actually
show their face over the next few years -- $100-$200 billion is a
reasonable estimate -- no one really knows where they are hidden.

First believed to be confined to Bear Stearns hedge funds and their
proxies, Waldos have been popping up with regularity in seemingly
staid institutions such as German and French Banks that have
necessitated state-sanctioned bailouts reminiscent of the Long Term
Capital Management Crisis of 1998. IKB, a German bank, and BNP
Paribas, its French counterpart, both encountered subprime meltdowns
on either their own balance sheet or investment funds sponsored by
them. Their combined assets total billions although their Waldos
are yet to be computed or even found.

Those looking for clues to the extent of the spreading fungus should
understand that there really is no comprehensive data to allow
anyone to know how many subprimes actually rest in individual
institutional portfolios. Regulators have been absent from the game,
and information release has been left in the hands of individual
institutions, some of whom have compounded the uncertainty with
comments about volatile market conditions unequaled during the
lifetime of their careers. And too, many institutions including
pension funds and insurance companies, argue that accounting rules
allow them to mark subprime derivatives at cost. Defaulting exposure
therefore, can hibernate for many months before its true value is
revealed to investors and importantly, to other lenders.

The significance of proper disclosure is, in effect, the key to the
current crisis. Financial institutions lend trillions of dollars,
euros, pounds, and yen to and amongst each other. In the United
States, for instance, the Fed lends to banks, which lend to prime
brokers such as Goldman Sachs and Morgan Stanley, which lend to
hedge funds, and so on. The food chain in this case is not one of
predator feasting on prey but a symbiotic credit extension, always
for profit, but never without trust and belief that their money
will be repaid upon contractual demand.

When no one really knows where and how many Waldos there are, the
trust breaks down, and money is figuratively stuffed in Wall Street
and London mattresses as opposed to extended into the increasingly
desperate hands of hedge funds and similarly levered financial
conduits.

These structures in turn are experiencing runs from depositors and
lenders exposed to asset price declines of unexpected proportions.

In such an environment, markets become incredibly volatile as more
and more financial institutions reach their risk limits at the same
time. Waldo morphs and becomes a man with a thousand faces. All
assets with the exception of U.S. Treasuries look suspiciously like
every other. They're all Waldos now.

The past few weeks have exposed a giant crack in modern financial
architecture, created by youthful wizards and endorsed as a
diversifying positive by central bankers present and past. While
the newborn derivatives may hedge individual institutional and
sector risk, they cannot eliminate the Waldos. In fact, the inherent
leverage that accompanies derivative creation may foster systemic
risk when information is unavailable or delayed in its release.

Nothing within the current marketplace allows for the hedging of
liquidity risk, and that is the problem at the moment. Only the
central banks can solve this puzzle with their own liquidity infusions
and perhaps a series of rate cuts. The markets stand by with
apprehension.

But should markets be stabilized, the fundamental question facing
policy makers becomes: What to do about the housing market?"

Granted, a certain dose of market discipline in the form of lower
prices might be healthy, but market forecasters currently project
more than two million defaults before this current cycle is complete.
The resultant impact on housing prices is likely to be close to
minus 10 percent, an asset deflation in the U.S. never seen since
the Great Depression.

Granted, stock markets have periodically retreated by significantly
more, but stocks have never been the savings nest egg for a majority
of Americans. Seventy percent of American households are homeowners,
and now many of those who bought homes in 2005-2007 stand a good
chance of resembling passengers on the Poseidon -- upside down with
negative equity. A 10 percent "hook" in national home prices is
serious business indeed. It's little wonder that Fed, Treasury, and
congressional leaders are shifting into high gear.

Housing prices could probably be supported by substantial cuts in
short-term interest rates, but even cuts of 200-300 basis points
by the Fed would not avert a built-in upward adjustment of ARM
interest rates, nor would it guarantee that the private mortgage
market -- flush with fears of depreciating collateral -- would
follow the Fed down in terms of 15-30-year mortgage yields and
relaxed lending standards.

Additionally, cuts of such magnitude would almost guarantee a
resurgence of speculative investment via hedge funds and levered
conduits that have proved to be the Achilles heel of the current
crisis. Secretary Paulson might also have a bone to pick with this
"Bernanke housing put," since it more than likely would weaken the
dollar -- even produce a run -- which would threaten the long-term
reserve status of greenbacks and the ongoing prosperity of the U.S.
hegemon.

The ultimate solution, it seems to me, must not emanate from the
bowels of Fed headquarters on Constitution Avenue but from the West
Wing of 1600 Pennsylvania Ave. Fiscal, not monetary policy should
be the preferred remedy, one scaling Rooseveltian proportions
emblematic of the Reconstruction Finance Corp., or perhaps to be
more current, the Resolution Trust Corp. in the early 1990s when
the government absorbed the bad debts of the failing savings-and-loan
industry.

Why is it possible to rescue corrupt S&L buccaneers in the early
1990s and provide guidance to levered Wall Street investment bankers
during the 1998 LTCM crisis, yet throw 2 million homeowners to the
wolves in 2007? If we can bail out Chrysler, why can't we support
the American homeowner?

The time has come to acknowledge that there are precedents aplenty
in the long and even recent history of American policy making.

This rescue, which admittedly might bail out speculators who deserve
much worse, would support millions of hard-working Americans whose
recent hours have become ones of frantic desperation. And for those
who would still have them eat some Wall Street cake as opposed to
Midwest meat and potatoes (The Wall Street Journal editorial page
suggested that they should get darn good and used to renting once
again), look at it this way: Your stocks and risk-oriented levered
investments will spring to life like the wild flowers in Death
Valley after a flash flood. And if you're a Republican officeholder,
you'd win a new constituency of voters -- "almost homeless homeowners"
-- for generations to come.

Get with it, Mr. President and Mr. Treasury Secretary. This is your
moment to one-up Barney Frank and the Democrats. Reestablish not
the RFC or the RTC but create an RMC -- Reconstruction Mortgage
Corp. If not, make some modifications in the existing FHA program,
long discarded as ineffective. Write some checks, bail 'em out,
prevent a destructive housing deflation that Ben Bernanke is unable
to do. After all, W., you're "the decider," aren't you?

[Bill Gross is managing director of Pacific Income Management Co.
(PIMCO), a bond investment house in Newport Beach, California.]