Extreme Measures I: Bill Gross at Pimco

We’ve noticed a new theme among economics writers: Extreme Measures.

Commentators have suddenly looked into the abyss, either of the depth of the US subprime/housing problem or the progressing credit crunch that has already caused a seize up in the money markets, and are proposing radical courses of action.

Our first sighting was Paul Krugman, who in a departure from his normally sound policy proposals, said the Federal government should rescue victims of the housing bubble via buying up mortgages at a discount and renegotiating terms with stressed borrowers (he did at least admit this would require a tremendous amount of lawyering and said he was open to other means to achieve this end).

This week, we heard a broadly similar proposal from Bill Gross, chief investment officer of fund manager Pimco, which makes him one of biggest bond buyers in the world. He’s not afraid to take strong views; in one of his recent letters to investors, for example, he declared Moody’s and Standard & Poors to have been duped by ” the makeup, those six-inch hooker heels and a `tramp stamp,'” of wayward collateralized debt obligations, the complex instruments that have been distributed over the globe, many with subprime exposures.

In this month’s letter, Gross, like Krugman, calls for a rescue of beleaguered homeowners:

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 over two million defaults before this current cycle is complete. The resultant impact on housing prices is likely to be close to -10%, an asset deflation in the U.S. never seen since the Great Depression….70% of American households are homeowners, and now many of those that bought homes in 2005-2007 stand a good chance of resembling passengers on the Poseidon – upside down with negative equity….

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 Avenue. Fiscal, not monetary policy should be the preferred remedy, one scaling Rooseveltian proportions emblematic of the RFC, or perhaps to be more current, the RTC 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 2,000,000 homeowners to the wolves in 2007? If we can bail out Chrysler, why can’t we support the American homeowner?

It’s hard to know where to go with this, but let’s deal with a few inaccuracies first and then get to the gist of the argument.

Gross has rewritten a good chunk of financial history. The US did bail out Chrysler, but not at any explicit cost to the taxpayer. The government guaranteed a Chrysler bond issue, and orchestrated a cram-down of other Chrysler creditors. That was a one-off in the middle of the worst recession since the Depression.

As for the Resolution Trust Corporation, that entity came into existence not to line the pockets of S&L buccaneers but to liquidate failed S&Ls in a orderly fashion. Let me stress that point: failed. The US government was on the hook for payouts to depositors, since these banks were members of the Federal Deposit Insurance Corporation. The RTC had conflicting objectives: to minimize its burn rate (it took working capital and walking around money to manage the assets the RTC absorbed), maximize returns, get the assets sold as quickly as possible (the overhang of bad thrift assets, particularly real estate, was a threat to sound institutions in the same geographic area as the failed thrifts). The RTC came to be criticized by both Democratic and Republican Congressmen, but in retrospect, most observers think it did a good job in handling a huge and highly politicized task.

And the Gross puts a peculiar spin on the Fed’s role in the LTCM crisis. As recounted by Roger Lowenstein in his book, “When Genius Failed,” LTCM had invited Peter Fisher, the head of the New York Fed’s trading desk, to look at its badly under-water positions (everyone on the Street at this point knew the hedge fund was on the ropes). Fisher quickly recognized that things were so bad that an LTCM meltdown could lead to a collapse of the markets. Over the next couple of days, Fisher ascertained that LTCM’s counterparties understood the risk and were willing to bail the firm out, but none would take the risk of being the initiator. Thus the role fell to the Fed. The Fed did not participate in the negotiations among the firms; it merely set the stage.

So RTC was a new organization to deal with a mess that was already in the government’s lap; the the Chrysler and LTCM initiatives did not involve hard costs to the taxpayer. None is a precedent for the sort of move Gross advocates.

Now to the merits of his proposal. Generally, economists look at equity and efficiency. Quite often, policy-makers must trade one off against another. But if a proposal gives you neither more equity nor improved efficiency, that suggests you should go back to the drawing board. Gross’s idea fails both tests.

Gross says, without any proof, that a 10% fall in housing prices would tank the economy and wipe out household nest eggs. It’s worth remembering that until roughly the mid-1990s, people bought houses because it was cheaper (all in) and safer than renting. Once you paid off that mortgage, real estate taxes and other expenses were low. Historically, people didn’t look to downsize in retirement and live off the proceeds; the advantage of home ownership was that the high-cost period when you had mortgage payments coincided with your peak earning years.

In other words, the ides of “home as financial asset” is a very recent, and dubious notion. Robert Shiller tells us that housing prices since 1890 (no typo) have appreciated 0.4% a year. Historically, a CD has been a better store of value than a house.

But more important, what Gross calls for is a massive redistribution from taxpayers as a whole to people who bought near the peak of the bubble. The blogger Cassandra gives her take:

I think it is a noble thing indeed to rescue the home-owning people and so save America from errrr itself(?!?). But which home-owning people? Are two-home-owning people more deserving of a life-buoy than than one who owns but as single home? …..Are the folk who bought stupid interest-only low-teaser-rate mortgages more deserving than the ones who simply paid too much and find themselves in negative equity? Should we save those that patriotically took out home equity loans following 9-11 in order to spend as they saw their patriotic duty? Or should we “save” those who continually withdrew equity from their homes to cruise the world or buy a plasma TV, such that, like Icarus, they simple consumed too close to the sun?!? What about the people, who deserved the good life, and in whose pursuit deserving stretched to buy an extra 2000sq ft with pool, 3-car garage, and gallery ceilings, leaving no wiggle room for the inevitable “shit” that all-too-often happens in the course of life….

But I will ask the question: Are not the savers deserving too? Perhaps the savers should unite and ask the government to provide them with some redemption for the lax fiscal policy and negative real interest rates that have spawned inflation in the real basket of goods and services one uses and consumes each day. It IS perverse justice that the prudent one’s who save for a rainy day, and consider wisely, the possibility that something might upset the best laid of plans, and so do NOT borrow 6-times their income on absurd luxury that the less wise did, and who as a result were so stretched they could not afford to landscape in the first instance, nor now they can afford the energy to heat or cool the royal waste of space. Where is culpability or responsibility?

So much for equity.

As for efficiency, consider what Gross is really suggesting. Cut to the chase, he wants to arrest the fall of a housing bubble through massive government expenditures. Let’s look at what has happened in other countries that had large declines in real estate prices.

The housing recession of the early 1990s was far worse overseas…..

In the late 1980s and early 1990s, the United Kingdom, Finland, Norway, and Sweden experienced peak to trough falls in prices of greater than 25 per cent. Sharper falls have been observed in some South and East Asian economies over the 1990s, particularly in Hong Kong and Japan.

….yet despite Gross invoking the specter of the Depression, these economies suffered only short, nasty recessions. UK GDP fell 2.5% in 1991 and 0.5% in 1992.. According to NATO, Finland had a steeper fall because its contraction was caused by economic overheating, depressed foreign markets, and the dismantling of the barter system between Finland and the former Soviet Union under which Soviet oil and gas had been exchanged for Finnish manufactured goods. Thus its fall in housing prices was more a consequence than a cause of its recession. Sweden similarly suffered from disruption of its trade relationship with the former USSR. Hong Kong has enjoyed high growth and volatile real estate prices, but the only year it had negative GDP growth was 1998, the year after its reunification with the mainland, when it suffered a major capital flight.

So while these economies all have different structures than the US, their experience nevertheless suggests that even severe housing recessions do not inflict long-term damage. I’d very much like to hear the views of those who have studied the international record more deeply, but this quick survey suggests the price of a housing recession is a sharp but short-lived real economy contraction.

Japan is the one example of an economy which socialized the costs of its bubble economy rather than have its citizens and institutions take too much pain. Recall that its housing and real estate bubbles of the late 1980s were far worse than ours. The Nikkei was 39,000 at its peak in 1989 (its recent high nearly 20 years later was only 18,000). A Tokyo luxury apartment (3 bedrooms, roughly 1100 square feet) in Hiroo Garden Hills in 1989 was worth $5 million (roughly $7.5 million in current dollars). Commercial real estate in Tokyo was if anything more inflated and Japanese banks, which did not do cash flow lending, would lend 100% against fictitious land values (for a host of reasons, mainly punitive taxes and an extreme attachment to real estate, central Tokyo real estate almost never traded).

Now the sheer magnitude of Japan’s bubble probably did make too much harsh medicine an unrealistic option. Most economists attribute Japan’s anemic growth of the 1990s to a combination of borderline deflation and the impact of an aging population. But keeping bank assets tied up in bad loans has also played a role. It wasn’t until 1995, for example, that the Ministry of Finance deviated from its “no failure” policy and allowed some small insolvent institutions to close and not until 1997 that the insolvencyy of the fourth largest securities firm, Yamaichi, forced MOF to accept a more Darwinian model. A recent Economist article states that it has taken the banks 17 years to work off the bad debts. But my Japanese colleagues point out that the cost of being preoccupied that long with workouts is that the skill level of Japanese financial institutions is behind that of Western firms. Now that they are free to compete, finally, they will find it an uphill battle.

Japan provides a warning in another respect: if the powers that be take steps that have the effect of keeping our bubble going, we may hit the point, like Japan, that we have to socialize the losses, that the costs of an unraveling are too high. But Japan had the luxury of sorting itself out at a time when the rest of the world was experiencing solid growth. And cynics point out that it may have served Japan to play up its image as a basket case, so as to keep the West from getting upset at its chronic trade surpluses.

But now, the bubble isn’t just in a few asset classes in a couple of (admittedly large) economies. Thanks to greater integration of financial markets, asset inflation is substantial and involves more countries and asset classes. If we keep rolling it forward and eventually, collectively, have to socialize the costs of an even greater unwind, who will be left to be an engine of growth?