Market Report: April 2008

Help is on the way. Although the major candidates have staked out predictable positions on the issue, I think some form of consumer-level bailout is going to happen. I am sure it has plenty to do with the fact it is an election year. In the past, we have been much more willing to allow the business cycle to finish and determine the winners and losers. There seems to be some consensus this time around to try a new direction.

Winners and Losers

Last month I wrote that a Federal program to assist homeowners facing foreclosure would soon be enacted. I envisioned a New Deal-style program similar to the Home Owners Loan Corporation, that President Roosevelt described as an agency that "... that will greatly ease the mortgage distress among the farmers and the home owners of the nation, by providing for the easing of the burden of debt now bearing so heavily upon millions of our people." The philosophical underpinning of a program like this is the common assumption that as the housing market goes, so goes the economy.

I was not considering Bear Stearns. Last month the Fed engineered an arranged marriage between two storied investment banks. The rationale behind this particular taxpayer-supported bailout should sound familiar; it would be unwise to allow the complete failure of a major financial institution. Bear Stearns was a major player in creating, selling, and profiting from the thousands of complex financial instruments all derived from the simple home mortgage. The Fed had to provide the dowry because nobody in the room had any idea of what Bear Stearns was liable for or what it was worth. All they knew was that inaction could create a run on the nation's biggest investment banks, all because some guy in Stockton could not make his house payment. The bankruptcy of Bear Stearns would have been the first domino to fall and that had to be prevented at all costs. Ben Bernancke meets John Foster Dulles.

Last summer the rising number of mortgage defaults and soft home prices begat the sub-prime crisis. But this is 2008, not 1991. Between those bookends, the equivalent of a financial revolution in the mortgage business occurred. Mortgages were bundled together, sliced into pieces, resold and then repackaged again. The new 'products' then became fodder for even more inventive financial variants. It was pure genius, taking something as ordinary as a home loan and creating hundreds of new investment and insurance products, all to be sold and resold, scooping up millions of dollars in fees along the way. The problem is that absolutely no societal value was created by all of this financial legerdemain. Does this help explain why a townhouse in Manhattan costs eight million dollars?

Now it appears Congress is weighing in on this issue. Since this is an election year, we will see an avalanche of rescue plans pitched to the embattled middle class. The Fed will baby sit the loose cannons on Wall Street and try to avoid the embarrassment of another corporate bailout. This will be a losing battle unless we can save the guy in Stockton.

Mr. Bernanke has not ignored that reality. He has pledged that he will continue to inject as much new cash into the system as needed. The Chair has assured Congress and the nation that he is now more willing than before to run the printing presses to head off a serious recession or deflation. Having to play that hand is risky and it is not entirely his fault that he is holding such bad cards. Mr. Greenspan, while posing as an inflation hawk, allowed the housing bubble to get a bit out of hand. I know he has since distanced himself from that unhappiness and in fact claims he was powerless to cool off what he contemporaneously perceived to be a distorted market. His strategy to fight inflation, as well as rein in the real estate market, was to regularly rachet up rates. He probably had no other real options and ended up pushing over the first domino.

Excess liquidity carries with it the risk of future inflation, as well as exposing the dollar to more downside pressure, but the political dynamic made it an easier call. The Chair has made money cheaper, but the Law of Unintended Consequences will surely apply. Mr. Bernanke thought it worth tempting the inflation gods in order to mitigate the effects of the current economic malaise. There is also a political element at play; by the bold move of providing cheaper and more available money, he has taken some political authority from Congress. Since he lacks the political weight of his predecessor, he may achieve that status if his play works.

Fear now rules the roost. Perhaps reflecting the last seven years of our political culture, reason is not given much standing. There is a battle of definitions, ideology, and perceptions when it comes to assessing the economy. Therefore, each individual makes a personal determination about their economic state and acts accordingly. Congress and the President will be at political cross-purposes when it comes to this issue. The latter is burdened by his weakend administration and lame duck status. Congress, since most are up for re-election, will have much more to lose if they fail to provide at least the perception of some sort of common-man-Bear-Stearns-bailout. I have to give Mr. Bernanke his due. He had the courage to move out from the shadow of Mr. Greenspan and take bold action. Arguing about blame will do little to solve our collective problems. That will be the task for the winners this coming November.

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