Monday, October 20, 2008

Global Capital Asset Death Spiral

About a year ago the US market started seeing large asset write downs in the housing and financial markets. Since then, this crisis has spread to almost every asset class in the US. Auction Rate Securities [ARS], like student loans back fully by the US government that can't be sold. The Auctions for these cash equivalent assets have no bids. The same is true for all types of structured investment vehicles [SIV], like packaged mortgage securities [CMOs] and debt securities [CDOs]. Homes prices have falling over 10% on a national basis, the most since the great depression. Equities all over the world have fallen 20% or more.

Money is not rotating in and out of different asset classes. We are seeing a global Capital Asset Death Spiral [CADS]. As the FASB rules require firms to mark to market assets in markets that have no bids or liquidity such as ARSs, CDOs, and CMOs, these firms must write down their asset bases. Many of these financial firms will now be forced to sell assets - good and bad, for whatever price they can get - 20, 30, 40% of book value. So now good and bad assets have very low prices set on them forcing other firms with similar assets to also write down their asset bases, on and on and on...

Firms need to sell assets at reasonable prices to raise cash - not borrow money or dilute shareholders

Recent news of the Freddie (FRE) and Fannie (FNM) government takeover does little to stop the CADS. Institutions around the world are being forced to raise capital since their asset bases are being destroyed since there is no market for previously liquid assets. These firms do not need cash, they need to sell their assets(at, or near current book) for cash. If this asset death spiral continues, the US will move from a recession to a 1930's type depression.

One could argue that we need to allow free markets to solve this problem. I would agree with this if the asset death spiral were caused by free market systems. As I will explain, the previous credit bubble and current asset death spiral were caused to a great degree by actions and inactions of the federal government.

The large credit bubble created from 2003-2007 and CADS had the following causes:

1) Historic low 1% fed funds rate
2) Poorly targeted tax cuts for the wealthy
3) No lending oversight or evaluation
4) FASB mark to market rules

My theory is fairly simple. Too much liquidity chasing an ever shrinking yield. After the US depression in 2001-2002 the federal government lowered the funds rate to 1% and kept it there. Wealthy investors were stumped. With short and long term risk free yields at pathetic low levels cash was getting very hard to invest. Investors were still hurt from the stock market crash, so these investor would not put their cash in equity markets. Then the US gave large tax breaks to these wealthy investors, giving them even more cash per year to handle. What to do with all this cash?

The combination of historic low yields, fear of equities, and a poorly targeted tax cut had created a HUGE increase in the demand for a stable return on all this cash. Can you say SIV, or CMO? Where you have demand supply will not be far behind. The larger banks and investment firms increased the creation of these SIVs with CMO and, CDOs to satisfy the large increase in demand for yield. A 5-6% yield will do just fine in this now low yield environment. Banks would now bundle 1000's of mortgages to create these new higher yielding financial vehicles.

To satisfy this large increase in supply of SIVs, lending standards had to fall. There is no other way to meet this new demand for yield, much to the glee the home builders, mortgage lenders, house flippers, etc.

The US solution - The Asset Investment Fund

We need a resolution trust type fund to invest in the US economy. An original funding of 300 - 500 billion would be needed. This fund would buy CDOs, CMOs, ARSs, developed land, raw real estate, and foreclosed property. These assets would be help the the government 5-7 years then slowly sold back into the market, probably at a profit for the US taxpayer.

The US can borrow money very cheaply , below 4% currently. Our trading partners such as Saudi Arabia, Russia, China, Canada, etc. would help as a strong US economy is in their best interest as well. The average yield of the assets purchased by the US investment fund would be greater than 6%. A positive spread of 2% could be realized for the US. Remember the money needed for this fund will be borrowed cheaply, not come from taxpayers directly.

By investing in these assets, the US will initiate market liquidity and create stable pricing environments for capital assets. This will help the US avoid having to infuse billions of dollars in GSE bailouts and avoid the many FDIC insured bailouts in the future. By investing 300 billion upfront, the US could avoid over 300 billion in bailouts over the next 2 years!

But what about the poor US taxpayer?

I can already hear the fear mongers. A US investment/bailout will just hurt the US taxpayer. If the asset death spiral continues, the US will not have many taxpayers left. State and local municipalities will not be able to raise funds as bonds can't be sold and home prices continue to fall. We will continue to see local government declare bankruptcy along with many regional banks. The remaining banks will be unable to fund ANY projects, even ones with solid cash flows. With no financing available jobs will continue to be lost, creating more home foreclosures and the death spiral continues....

This investment fund will restart the financial systems and help create jobs and insure a solid taxation revenue base for the future. This is the definitive issue in the US economy.


Authors note: I first published this article on Seeking Alpha on Sept 9th, 2008 - before any US bailout was announced.

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