Monday, October 6, 2008

Election FUD on U.S. Economy

I noticed that in the vice-presidential debate, Joe Biden tried to take McCain to task for making bullish statements about the U.S. economy. Maybe he should give the same lecture to Warren Buffett. Buffett has spoken about the need for a bailout, and about the housing inventory, and about the effect of leverage against mispriced mortgages on the balance sheets of banks that were more worried about their quarter than about the future. Throughout, however, Buffett's statements about the economy -- not the balance sheets of lenders, but the U.S. economy -- have been long-term bullish. (Example: "It has not paid to sell American short since 1776, and the time to start is not 2008." This, in August 2008.)

Buffett likened the U.S. economy facing the current mortgage crisis to "a great athlete" needing resuscitation following an unexpected heart attack. Rather than point fingers and discuss whether the patient ought to have trained or eaten differently, Buffett stated the important thing was to get out the rescussitating equipment and start working. The athlete needs to be put back in shape for competition. Buffett didn't say the patient needed to be retired, or that the patient was no athlete at all and shouldn't be outdoors exercising.

Speaking on the housing oversupply, Buffett stated that the United States creates several million households per year, and that the surplus will simply be worked off, though not overnight. He doesn't sugar-coat that it's a problem, but he emphasizes that the characteristics of the United States' economy create reasonable confidence in recovery -- and that the things we do now to mitigate the current liquidity issues brought on by subprime mortgages can accelerate the recovery that would occur if the market participants were allowed to crash and burn as a result of the subprime-related excesses of banks.

Buffett isn't alone in thinking the U.S. economy is a place of opportunity. A manager of a much smaller pool of money, American Capital's Malon Wilkus, stated that the financial problems currently observed remain quite specific to the home mortgage market, and those who levered against it. Wilkus gave the commercial real estate market as an example of a near industry that simply wasn't showing defaults or other significant problems. But for exposure to the suddenly-illiquid subprime mortgage market, participants in the U.S. market seem healthy.

The subprime problem is a problem of home mortgages and the institutions that mispriced the risks these mortgages offered their balance sheets as they levered their balance sheets against what proved to be an unmarketable asset. The problem -- the reason that the ripples are so large, and are creating problems for people who never thought they were investing in risky mortgages -- has to do with the economic relationships of the entities in the subprime mess.

A writer at Seeking Alpha claims that with AIG alone requiring $85 billion to keep afloat, the market is doomed because the recently-passed bailout $700 billion bill won't be nearly enough to halt the tsunami. This kind of sloppy thinking from a pessimist is exactly how sloppy optimists got it wrong to create the current mess. A little attention to the substance of the transactions will save embarrassment later. AIG didn't just consume a $85 bailout. The Federal Reserve Bank just opened AIG a two-year line of secured credit bearing a loanshark-like cost, giving AIG a little while to straighten out its balance sheet so it doesn't become insolvent in a quarter or so. The Federal Reserve Bank now holds warrants on 79.9% of AIG's shares, so that if AIG pulls out of its subprime-caused nosedive, Uncle Sam will be its new business partner.

The reason $700 billion in illiquid assets clogging a financial institution's balance sheets is a disaster is because the reason financial institutions are able to impact financial markets in the normous way that they do (Buffett recently stated Americans' participation in the public markets amounts to something like $20 trillion, and banks move this market all the time) is that most financial institutions use enormous leverage when they operate. Assuming an institution is levered at a relatively modest (for a bank) 10:1 (debt:equity), $100 billion in assets becoming so illiquid that no-one will take them as collateral effectively wipes out $1 trillion in assets the institution can borrow to make available for ordinary (that is, fiscally sound) financial transactions. At this level of leverage, a $700 billion investment in currently-unlendable assets in exchange for cash would replace $7 trillion in currently-missing market liquidity. That's more than a third of Americans' stock ownership, using Buffett's numbers. That's nothing to sneeze at.

The federal government is planning to get paid pretty well for this investment. Buffett said that if the purchases are made at current market prices, he'd like to invest his own money alongside the Treasury. Moreover, the Treasury will be taking equity stakes from institutions who want to drink deeply from the well. Anyone Treasury saves from that big a gaffe has a new partner in business.

But back to the candidates: if McCain says the U.S. ecomony -- which creates millions of new households per year and despite record oil prices has managed to narrow trade deficits through increased exports -- is fundamentally strong, one would expect some argument why he's wrong.

Biden offers no argument, he just points and laughs. Biden is trading on economic panic to persuade the fearful that his opponent is out of touch. It's possible that, by contrast, Biden himself has no idea what's going on or why, and hopes you don't, either. McCain appears simply to take the fairly unremarkable view Buffett has long endorsed, which is that the U.S. economy is a long-term bull play and remains so. This is in no way inconsistent with the view -- also endorsed by Buffett -- that quick action is needed to speed recovery from the financial sector's Kool-Aid-splashed subprime home mortgage orgy.

Biden's observation -- that McCain professed confidence in the U.S. economy and then called for immediate action to protect it from the subprime meltdown -- doesn't prove his thesis. Biden is just pushing election-season FUD, when constituents might like to hear substance.

Because Obama didn't answer in the first debate what specific platform planks he'd sacrifice in light of fiscal pressure brought on by the subprime mortgage crisis, we don't know if he intends imposing his new payroll tax immediately, or in eight years. Biden, who was busy laughing at McCain's confidence in the United States economy, didn't care to share his view, either.

No comments: