Housing Doom

Well I think at some point we’re going to have a government in power that’s going to make a choice between the American people and our creditors, who are predominantly foreign. And I think that choice will involve letting the dollar depreciate. I don’t think we’ll ever actually repudiate our debts, as long as we can print more dollars. But I think that’s the fundamental political issue that faces our entire society … – Chris Whalen

Doom Transcripts: Index & Guide

Housing Doom is pleased to present a eighth and final selection from our under-construction transcript of the American Enterprise Institute’s October 22, 2009 event "The Deflating Bubble, Part VI: The Lessons of the Bubble and Crisis".¹

The event site has a number of resources, including an audio and video of the proceedings. There is as yet no official transcript.

The lively Question and Answer session that closed the conference featured everything from Roubini’s lurid medium term scenarios to Zimmernan’s surprising advice that Re-remics, along with just about any other recent real estate securitizations, are perfectly safe to buy.

Alex Pollock: [1:31:26] Let me come to our questions. We’re going to, we have microphones, a microphone in the back. Please remember how this works. Wait for the microphone, please tell us your name and your affiliation, and then ask your question. For those of you who may feel the urge to make an assertion in addition to your question, may I ask you to keep your assertion short and to the point, otherwise I’ll feel compelled to ask you to come to your question. … I have a hand way in the back, here. … Oh, it’s Bert [laughs] …

Bert Ely: I was hiding on you, Alex. Bert Ely, banking consultant. A suggestion and a question. In terms of describing the kind of recovery you have, let me offer another suggestion to you that I’ve been using. I call it a washboard recovery. Slow and very bumpy over the next few years.

My question relates to something that some of you have alluded to, Desmond particularly, but I think needs a little bit more attention. And that is as we look at the economy coming out of this recovery, to what extent can Congress help or hurt the recovery through its various regulatory reform activities. We have a lot of that percolating along right now — executive pay limits, the CFPA and who knows what else?

So I’d be interested in what the panel’s thoughts are as to the dangers, if you will, to the recovery from Congress’ initiatives and the Administration’s initiatives to try and prevent a repeat of this crisis.

Alex Pollock: [undecipherable] … would you take this?[ph] Well, you have the pendulum point, Tom, …

Tom Zimmerman: Yeah, I mean I think those are probably minor things. It’s not good, it’s certainly not going to help, but I don’t think that’s the, you know … Yeah, you shouldn’t be doing that right now, but I think those are probably minor things compared to some of the broader pictures, broader comments[ph] and issues we’re dealing with here.

I don’t think that will, in itself, stifle the … It’ll cost more for the average consumer for his credit card loan, for his credit card debt, for his car loans. And a sustantial number of Americans won’t be able to get a loan, that’s what will happen, because you will price people out of the market.

But yes, you will have a safer and sounder system to some extent, but you will pay for it.

Nouriel Roubini: Anything wrong with having lots of people not being able to borrow, since this is a crisis of overborrowing?

[laughter]

Tom Zimmerman: No … I don’t know … if you …

Nouriel Roubini: No. Seriously.

Tom Zimmerman: No, but if you … One of the reasons we have payday lending is because banks don’t lend to a lot of people now. I suppose payday lenders will get an exemption, just like we have a lot of exemptions out of the new Consumer Finance Act, we’ve got all sorts of [undecipherable] exemptions because Congressman [tape skip] wants it that way. But I don’t know where it ends, but … Yeah, you know even the Mafia lends money too. You know, we … Yeah, for a rate, right.

So, you know, if you restrict the functioning system, in a way there will be lending, it will take place, it’s just whether it takes place through the back door, or through the front door.

Alex Pollock: Just a quick comment then, and we’ll go onto another question.

Chris Whalen: You know, the "legislative reforms" quote-unquote on the Hill are not about helping anyone. They’re about building monuments. Both Shelby and Dodd want to build a monument to consumer protection. Meanwhile, we will not have meaningful reform in the one area that is crucial, which is Over the Counter [OTC] Derivatives. If you look at the latest turn of the legislation on the House side, it pretty much leaves the dealers alone. They might as well not even pass it, there will be no change.

Alex Pollock: I have a question back here …

Brian Gardener Brian Gardner with [1:35:00] Keefe, Bruyette & Woods. Kind of staying on the theme of legislation that’s up on the Hill. It’s interesting to … after every member of the Committee has been recognized over the last couple of days, after they say think-you Mr. Chairman, the next statement is, "We can never let this happen again." In 1913, you know, and it was "We can never let this happen again." When we set up the banking and regulatory system in the ’30s, "We can never let this happen again." When we did FedICIA and FIRREA, "we can never let this happen again."

And this seems to be playing out.

One thing that has not been touched on today, and I’d like your collective opinions on this, is, "Where should we be going on … more on the regulatory side, with bank capital standards?"

Alex Pollock: Somebody want to take up bank capital? John?

John Makin Well the answer to the comment is, "We can, and we will." [laughs] I think the lesson of all these iterations is that there’s no magic regulatory bullet. And the notion that somehow there is, is probably what fosters the problem. And again the Congress is not very good at designing legislation that fosters better performance in the financial system, and there’s no reason why you would expect them to be. They’re ignorant of what goes on in the financial markets and, let’s face it, they’re driven by (*gasp*) political motives.

Why else would you — again, to go back to a comment that Nouriel said … This crisis was caused by massive government subsidies to purchase homes by people who couldn’t really afford them. So what does Congress do? They pass an $8,000 tax credit for people who can’t really afford to buy a home to buy one. I mean, how stupid can you get?

So we can’t let this happen and we won’t? Nonsense: we can and we will.

Alex Pollock: Chris …

Chris Whalen: To pick up on John’s comment, the Congress doesn’t have a problem at the moment. They don’t see a crisis, because as long as the Treasury can borrow and fund their activities without their having to go back to the electorate and raise taxes they have no problem. The only time the Congress in the United States will have a problem is if the Treasury market has a failed auction. That’s when they start to have a real political problem, but at the moment, they have no problems.

And that’s why we see this ridiculous Kabuki on Capitol Hill. It has nothing to do with the actual problems of the country, it has to do with those members of the political class remaining entrenched. And as long as they can sell bonds, they’re going to stay right where they are.

So the policy moves that they take really have nothing to do with our collective wants and needs, really. I don’t think the Congress is at all representative anymore, even though John’s characterization is completely right.

You know, it took 30 years for the Congress to study market structure problems between the 1880s and the beginning of the Roaring ’20s. That’s how many crises we had to go through before we finally got Glass-Steagall; people forget that.

Alex Pollock: I have a question right here when … well OK, we’re going to move forward, to the right-hand side here.

Steve Votaw:OK [undecipherable] was my microphone. Steven Votaw with Deloitte consulting. I have actually two questions, and I think in light of what we’ve all talked about in terms of this bubble, like the housing bubble and the concentration of all banks in housing, I’m not convinced that the too-big-to-fail would really work. I mean wouldn’t … if we had a lot of smaller banks, wouldn’t they all just fail at the same time?

And then the second part of the question is — Desmond, you have only 10 percent down on home prices? But it seems like that backlog of foreclosures is pretty huge. Why only 10 percent down?

Alex Pollock: Both those questions are for you, Desmond.

Desmond Lachman: Just remind me of the first one …

Alex Pollock: If you had a whole lot of small banks, instead of a few big ones, wouldn’t they all just fail.

Desmond Lachman: … Do you know, if you had a lot of small banks, all doing exactly the same kind of thing, all being being subjected to exactly the same kind of shock, I would agree with you. But that’s hopefully not what you’re going to get in a very competitive system where you’ve got a lot of small banks doing different things.

So you could allow banks to fail, and that that would send very good signals. You know, you would get rid of moral hazard; you wouldn’t just have these banks able to borrow indefinitely knowing that the borrowers are going to be bailed out.

10 percent … I certainly think that prices could overshoot and I’d want to see what happens. If what I’m thinking is going to occur, we do get a double dip. Then I think you certainly could go way below.

I think that a point that Marty Feldstein [1:40:00] keeps making is that in the same way as you overshot equilibrium you can undershoot on the way down. There’s nothing magic about it. I think that there’s a dynamic process.

What would concern me is if you get yourself into a loop with lower prices causing more people to be underwater, creating greater incentives for people not to want to pay their mortgages you know we’ve really got a problem.

Alex Pollock: Nouriel?

:Nouriel Roubini Yeah, but in …

Alex Pollock: We’ll get Nouriel quickly and Tom, and then we’ll come to the next question.

:Nouriel Roubini Yeah, on the issue of many smaller banks I actually agree with the view that you can have systemic risk even if you have thousands of smaller banks. I mean one example was, you know, the S&L crisis — 1,400 of them went bust, none of them was a Lehman or a Bear (systemically important), meaning if there are conditions that create a bubble, whether it’s easy money, poor regulation / supervision, subsidization by the government of housing or whatever, you’re going to create a bubble, and then everybody’s going to behave the same way, it’s going to go bust, and then you have a systemic banking crisis.

So certainly too-big-to-fail is a problem, but unless we go to the core of the reasons why everything [undecipherable] bubble in the United States that goes bust, and then we have a severe economic / financial crisis is going to happen over again if we had lots of small banks.

Alex Pollock: Tom …

Tom Zimmerman: Yeah, I was going to say pretty much the same thing only from subprime perspective. We had a bunch of small subprime lenders and they were all doing the same thing. And because the regulators didn’t come down and say, "You can’t make these kind of really idiot loans." If you were in subprime lending and you didn’t do it, you were out of business.

So it’s the old, "You have to …", the bad loan drives the good loans out, clearly. And if you’re a … if you get by of those bad loans, people love it and they’ll go for it, and that’s why you need regulation.

Alex Pollock: There’s a famous saying of John Maynard Keynes that the market can stay irrational longer than you can stay solvent. That’s on the downside. On the upside, which is what Tom just described, there’s a parallel saying, "The market can stay irrational longer than you can stay employed." And therefore, you participate. I have a question right here. Go ahead.

Jack Phelps[ph]: Yes, Jack Phelps[ph], FHFA. I think along the lines of dealing with systemic risk, TBTF, I think Chris touched on, one of the necessary reforms is moving OTC derivatives to a clearing house. I think that’s a necessity. I think the other part that we hear zero discussion of … I think Alex maybe had a thoughtful piece² in the American Banker a week or two [ago] on this, is perhaps separating payments from commercial / merchant investment banking, and let’s treat the payments system as a utility, let’s protect it, not let it be affiliated in that kind of structure.

And if me move to that, then we can have these large firms fail, we can protect that. So I think that’s a necessary reform. Perhaps somebody can comment on that.

John Makin: Yeah, I would just say that I agree with the need to have banks that are focused on transaction services. But investment banks remember, that are large and subject to counterparty runs like we saw last September, can bring the system down. So there is a size issue there.

And so I think we have to be aware of that as well.

[crosstalk]

Alex Pollock: … OK Chris …

Chris Whalen: Remember Bear and Lehman were clients of banks, as John was saying. So having them not directly plugged into the clearing systems doesn’t help you. But what I do think we have to move towards, and you’ve heard it kind of discussed in the regulatory community, is — make debt of these holding companies convertable. And I mean all of it. You could do it in 10 percent increments.

Because then, you’ve got the resolution baked in, and we can stop talking about winding down these large institutions. That’s not what we need. We need to fund them, and [tape-skip] do stupid things, the bondholders have to know that they’re going to convert.

Alex Pollock: … just say what that means — what do you mean, "convert"?

Chris Whalen: Well now, [undecipherable] if you had Citi last year. Before the government put equity in, instead the bondholders would have been told, à la GM, "you’re converting into equity." You drop the interest expense of the entity immediately, and the next day you charge off … You know, Citi holdings, to give you an example, has about $300 billion in assets, half of which are covered by loss sharing agreements. If instead we had charged that off and used the new funds from the bondholders to recapitalize the entity, we’d be done. You’d never have to write a check again, if you’re the public perspective.

Alex Pollock: You’ve been waiting here up in the front … Then I’m going to come to the back here next.

John Serrapere Yeah, it’s John Serrapere from Arrow Insights and from Pittsburgh. One of the things I wanted to comment about is I want to thank you for putting on these presentations. I’ve made 5 of 6. It feels like I’ve made 12 of 9. [laughter] But it’s been a most rewarding in terms of my research. I just want to thank everybody.

But the question I had is — When the G20 was going on in Pittsburgh [1:45:00] I was able to get in some private forums (pre- the G20, of course) and one of the things I’ve learned that I didn’t know is that, one, it’s the G23, and another one is that … because there’s three members that really are always there.

But I learned that there’s a piece in NAFTA in 1999, drafted by Geithner, that actually prevents financial regulation for global financial intermediaries. So if we passed a law here and the banks are involved in other countries, it can’t be enforced in terms of the free trade. And Geithner actually drafted this when he worked for the Administration.

Now it’s a clause that’s reviewed, and it’s apparently being reviewed and it’s going to be added to the new Doha round? And it would revert, make impossible for you to reverse anything that was drafted after 1999 on a global basis. And I was unaware of this, but I was wondering if anyone in the room understands its impact on financial regulation.

Alex Pollock: Any comments?

Nouriel Roubini: I mean, the only point that I’d make is that whatever you have to do, you have to do at the global level, otherwise there would be jurisdictional arbitrage. And so whatever agreements are made about reforming the system of financial[ph] regulation, we cannot do more than others or vice versa … otherwise it would be a game of jurisdictional arbitrage.

Alex Pollock: Thank-you. Can I have a question way in the back here?

anonymous questioner: Why should we, and pardon me, maybe this is naive, but speaking to the international matter here, because I think we’re looking at a macro solution, but …

First, why should we be worried about jurisdictional arbitrage if we decide that our macro solution would be, first, keeping our Constitution? So Article 1, Section 8 compliant trade would be demurring on keeping G20 agreements. So what do you say to us where we decide that, you know, we’ve got to clean up our house here?

Because we’re not going to have enough people who can pay their mortgages and buy cars and things like that, you know, once you’ve offshored their production into one of the former colonies of our allies, which is in effect complying with … US’ compliance with the G20 agreements is collapsing our economy and offshoring our productions.

So Free Trade’s been [crosstalk] … but that’s my question, you know. I mean. what are you say that [crosstalk] where our macro solution’s are something we need to do?

Alex Pollock: … What are we … how are we to answer this naive question? Why do … as you said, why do we care about this international jurisdictional issue?

Chris Whalen: Well I think at some point we’re going to have a government in power that’s going to make a choice between the American people and our creditors, who are predominantly foreign. And I think that choice will involve letting the dollar depreciate. I don’t think we’ll ever actually repudiate our debts, as long as we can print more dollars. But I think that’s the fundamental political issue that faces our entire society …

To what extent are we going to go along with this wishful thinking about a global economy when we still have entities that are national?

And look at banking. Look at Basel II. There is no global framework here. There is no global accounting system. There is not even a global definition of default, for chrissake. So how can we pretend that this is a global regime for capital adequacy?

Alex Pollock: One minute in the penalty box for the profanity, but just do you …

Chris Whalen: … my name is Chris …

[laughter]

Alex Pollock: … do you favor a global accounting system, Chris?

Chris Whalen: It’s not possible.

Alex Pollock: Nouriel …

Nouriel Roubini: I mean, if what we’re going to do is to essentially devalue the real value of our public debt and avoid debt deflation through inflation and debasing our currency (it’s an option), at that point, I think that the creditors of the United States are going to pull the plug.

Because if we’re going to the route of high inflation then China, the Gulf States, Brazil, Mexico, Russia, Japan, you name it, they’re not going to go and sit back and take the capital levy of hundreds of billions of dollars on their own dollar assets. And they’re going to run away.

Last time around we did it in the ’70s we were a net creditor country and a net lender. We were running current account surpluses. This time around we are the biggest net debtor in the world, to the tune of $3.5 trillion and we’re still borrowing on net half a trillion a year because we have a large current account deficit.

So you can try and impose that capital levy, then you have a sudden stop of capital and the dollar collapses, and then you have a spike in interest rates and you have disorderly stagflation again.

So it’s too easy to say we’re going to screw our creditors, because those creditors are not going to bend over and say, "I’ll take it." They’re going to run away, and it’s going to be nasty at that point.

[laughter]

Alex Pollock: John …

John Makin: Well I want to add, we’re all kind of in this … in the same dilemma.

Comment: that is … [1:50:00]

The maturity of US Federal Debt is very short, something on the order of 2 years, so the option of … It’s really not going to work very well if we try to zap our creditors.

And secondly, I don’t think that the Fed is in a mood to do this. I know everybody’s very sceptical, but I don’t think the Fed will play along. And that will cause some difficulties with the Fed’s independence, but this Fed will go down fighting to avoid the sort of simple-minded "inflate our way out of this" story.

Alex Pollock: Question right here please.

Barry Wood: Barry Wood, free-lance economics correspondent.

In terms of what Nouriel was saying about the dollar carry trade, what’s the solution to this. Can market deal with it?

There’s resistance in Brazil, that tax you mentioned. There’s resistance in Europe to seeing the dollar more than to $1.50 [== 1 euro]. What can be done as a corollary to force the renminbi in China to come up and not go down with the dollar?

Nouriel Roubini: Well I think that, you know, the trouble is that the Fed keeps on having zero rates and expects to keep them at zero. And the Fed reduces volatility by buying long rates, then the game everybody’s going to play is a carry trade. And that’s what’s happening right now and other countries are in trouble because either they intervene, like the Asians are doing, because their currencies are appreciating too fast. And if you intervene is unstabilizing intervention and therefore you increase your base money and credit growth becomes worse. Or you decide to cut interest rates, and that’s the same thing, because you try to avoid your currency from appreciating by following the US monetary policy. Or you try to do what Brazil does.

But they are all variants of the same, that imply that everybody around the world has to import our monetary policy, and therefore our easy money becomes a global easy money, and that particular bubble continues. And that’s the scary part of it. It’s really the scariest thing that’s happening right now.

People say the economy’s recovering, these asset prices are going up because of that. The reality is that money not only is free, but if you borrow in the US is a negative interest rate. And everybody’s playing exactly the same game. And people are not realizing that it’s the most dangerous game we’re playing right now.

Of course the trouble the Fed is facing is that it has two objectives. One is to stabilize growth and avoid deflation, and the other one to avoid financial instability.

But they’re using one instrument, the Fed Funds Rate, to achieve stability of growth and avoid deflation. But they’re creating exactly like 2003-2006, financial instability. Because at that time we kept the Fed Funds Rate too low for too long, and you normalize it too slow, too little. And we created the asset bubble, the mortgage bubble, the housing bubble.

This time around, is occurring on a global scale. It’s not just the US. What’s happening right now with this carry trade, is creating a global asset bubble that we haven’t seen in decades. And is going to go bust.

Alex Pollock: Nouriel, given all that, what’s your forecast for the price of gold?

Nouriel Roubini: Actually, you know, on gold, in my view, gold goes very high under two scenarios. One in which you have inflation, and the other one in which you have again, Armageddon, in which you cannot even backstop the financial system.

For the time being I see a glut of capacity globally, demand weak, weak recovery, and there’s deflation and firms cannot sell their goods and they’re slashing prices.

And on the labor side, slack in labor market — unemployment at 10 percent. So for the time being, I see just deflation around the world, and that cannot be good for gold.

Too, gold could sharply spike if we’re going to go back into, again, another double-dip in which we cannot anymore backstop the financial system. Because you’ve got governments that are going to be essentially having banks too-big-to-fail and too-big-too-be-saved. If you get into that world in which really we cannot backstop the financial system because they government is insolvent, that’s the time to buy guns, ammunition, canned food, [laughter] gold bars and run to your log cabin in the mountain.

That was the world after Lehman, and that was the world of February / March. That’s when gold went above $1,000 again, right?

So gold usually goes up when you have inflation, expectation like the first half of last year, or when we have catastrophe and Armaggedon. Those two theories, for now, have been reduced. The one of the inflation because you have this slack in goods and labor market, and the other one because we’ve decided to backstop the financial system.

If we have a double dip, that’s a different story. But in that case, before we get inflation then we get a near-Depression and stagnation.

Alex Pollock: Chris, quick comment and then a question coming here.

Chris Whalen Well you know it’s interesting, if you look at the UK real estate market right now, it’s going up, even though the economy there is flat. And I think what you’re seeing, to John’s earlier points, is that holders of paper money are starting to look for solid assets to buy.

So I think even in this country you’re going to see selective spikes upward in prices for really prime real estate, but only when it’s been marked down. [1:55:00]

Christine Eisner[ph]: Christine Eisner[ph] with KW Commercial. My question is regarding the re-evaluation of real estate mortgage investment conduits, or Re-remics.

How effective or ineffective do you think this this tool is in relation to the banks’ reserve requirements, and possibly the real estate industry.

Alex Pollock: Tom, you maybe want to take that one?

Tom Zimmerman: Would you say that again?

Christine Eisner[ph]: It’s the Re-remics. Re-evaluation of real estate mortgage investment conduits, regarding a bank’s reserve requirements? In other words, …

Tom Zimmerman: Is this the changed rule about the tax code you’re referring to? About the fact that for some commercial real estate CMBS you …

Christine Eisner[ph]: They’re re-evaluating the package of investment portfolios and they’re taking the good loans and they’re re-evaluating them upwards and taking the bad ones and …

Tom Zimmerman: Oh! Oh that. Oh, no. That’s not going to be a big problem. That’s … That’s just a matter of re-securitization. They’re taking a pool of securities — several pools of securities. Taking some of the … taking those loans and repackaging them and now selling off part of that as a triple-A again.

So it’s a little bit like they did before, only this time the rating agencies and the criteria for these Re-remics are so much stricter that investors will buy those triple-As without much concern.

Now we can say when they did that 4 years ago and got screwed, but under this current regime of the rating agencies, what they require for those Re-remics and the kind of collateral going into them, anyone that’s frugal is going to want to buy that stuff, because it’s just rock solid.

That’s a little bit like, if you can buy a mortgage loan created today, it would be great, because, you know, you’ve got 20 percent down and high LTVs and all that. So if you have the wherewithal to buy certain assets right now, even beyond this thing we’ve been talking about here, …

What happens, when banks go through a crisis like they did in 1990/’91 or like we’re just going through now, lending criteria, what few loans they make, are rock solid. So it’s a little bit like when they re-securitize these mortgage loans right now, this is the best of the best. So I don’t view this as a problem.

Alex Pollock: Alright, time for one more question. We’ll come to the back here.

Dale Kinsella[ph] Hi. Dale Kinsella[ph] with SSA. I was wondering if you guys could comment on there being a correlation between the economic downturn and the high unemployment and stagnant and falling wages. Is this … is there really not a big correlation, and this is more due to competition than labor markets from like China, for instance. And there being a lot more competition in the labor market in the United States.

Alex Pollock: … John? …

Dale Kinsella[ph] … 20 years ago an Ivy League law degree meant a lot more than it does today, for instance.

Alex Pollock: John?

John Makin: You know, look. I think when the economy … The primary pressure on employment is simply that there’s massive excess capacity and for most businesses labor is 70 percent of their cost base, so, you know, what we’ve seen … certainly over the past 6 months is, anybody who’s reporting better earnings is saying, "Well, we contained a lot of … cut a lot of costs." And they way to cut costs is to lay people off, and so that’s what we’re seeing.

The … So that scale effect is far more dominant than the substitution effect, which would be the operation of alternate production facilities abroad. It has some effect, but it’s being overwhelmed by a simple surge in excess capacity that forces people to cut a lot of costs as rapidly as they can. [1:58:44]

Notes and References

[1]: "The Deflating Bubble, Part VI: The Lessons of the Bubble and Crisis", AEI event homepage, October 22, 2009.

[2]: "Deposit Insurance a Persistent Problem", by Alex J. Pollock, American Banker / AEI, October 7, 2009.

On one hand, there is the fervent political desire to make deposits riskless for the public, so that depositors do not need to know anything about or care about the soundness of their bank. But their deposits fund businesses that are inherently very risky, highly leveraged and cyclically subject to much greater losses than anyone imagined possible.