In a note to file under the “Playing for Time” theme, the Curious Capitalist notes:

First American CoreLogic has taken a look at the effect of the government’s efforts to drive down mortgage interest rates, which, among other things, makes for easier refinancing. According to the loan analytics company, in the first half of 2009, refinancing homeowners set themselves up to save some $11.5 billion over the next five years. The typical person who refinanced was able to drop his monthly payment by $120 a month, a reduction of 10.5%… The value of mortgage originations hit $664 billion in the second quarter, and 69% of that was refinancing (by contrast, 37% of origination activity was made up of refis in the last quarter of 2o08). Fair or not, the government’s plan at least worked.

Reconcile this with one of the headlines on the site of Connecticut’s new candidate for U.S. Senate, Peter Schiff, which reads, “What America has succeeded in creating is not an economy impervious to shocks, but merely one which enables their consequences to be postponed to a later date.” I’ve spoken briefly with Peter before, and I’ve read his books, but I’m by no means in complete agreement with his views - yet in this instance, what he says is a perfect application to what the banking system is doing with the blessing of our government. Their strategy? Between the PPIP and mortgages, let’s sell as many options as we can now, book a benefit, and hope the adverse scenario that results in our option position(s) taking losses doesn’t occur.

I’ve wondered before whether or not we can carry trade the U.S. consumer back to health by attempting to force Treasury rates and other borrowing rates to converge; I’m not sure, but we’re certainly giving it the old college try.

If the typical person refinancing can save an extra $120/month, where does the money come from? It’s money that mortgage lenders aren’t making anymore in a lower interest rate environment. Now, the yield curve is steep, and short rates are near zero, so the relative change in rates is still helping banks. But at the same time, we’re more heavily leveraging banks to low rates; net interest margins might be getting fat at present, but they will compress and then some when rates inevitably rise. Zero, as James Grant has said, is the wrong rate for any economy, but more and more, I’m leaning toward believing that short rates stay extraordinarily low because of the idea that the economy depends on it - even when reality is that it aids speculators much more than the economy as a whole.

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One phrase I keep coming back to is “playing for time” – I see it as a good description of the strategy (or lackthereof) underlying most of the economic policy decisions that emanate from Washington.

What areas are being targeted, and how is it being accomplished?

Real Estate

Autos

Banks and Other “Financials”

The entire point of playing for time is to increase optionality. More information becomes available, and perhaps the economic situation will change for the better. But keeping businesses alive comes with indirect costs – more competition reduces the ability of healthier firms to pick up profitable customers – and with an implicit backstop from the government, borderline financial companies are incentivized to take more risks than usual.

The immediate result of those actions is to accelerate consumption, defer pain (losses), or interfere in allowing the market to set the prices it would otherwise set. To loosely quote a recent note from David Rosenberg, only in America are policies that encourage excessive consumption celebrated as a success. Yet that’s exactly what’s being done through a program like Cash for Clunkers, and the public reception has been very enthusiastic – a dangerous turning point in the series of bailouts.

I’m wary of data (and interpretations) suggesting that recovery is at hand, because uneconomic activity can only be encouraged for so long. That’s a lesson the Fed should have learned from previous heroic rescues during downturns, but chooses not to, because the expedient solution is to shovel money into any area of the economy that will take it.

Home prices, which undoubtedly went through an enormous bubble, are now the subject of a great experiment in controlled deflation. “Affordability” products sprung up earlier in the decade, when buyers had no savings for a down payment. Those turned out to have disastrous consequences, and yet policy now is directed toward offering what amounts to down payment assistance via a tax credit, and artificially low mortgage rates through the Fed’s market operations. We’ve been down this road before…

Boosting GDP for one or two quarters with the $3 billion (at present) Cash for Clunkers will quickly be revealed as wasted money; there are only so many new cars that people need. Most shrewd observers have realized by now that the program will skew statistics favorably for a time, without doing any real good. Of course, if the point is to save the “American” automakers, the program has been a failure on that front too.

The silent bailout of the financial system through zero interest rates and guaranteed debt is more pernicious – the TLGP, for instance, is estimated to be a $24 billion gift to those using it. And yet, little will be said about that as long as the impact on the Treasury’s borrowing costs remain marginal. Can we carry-trade weak financial institutions to profitability by leveraging the U.S. government’s borrowing ability? Likewise, can we store the health of balance sheets by stealing from savers through interest rates effectively at zero? We’re certainly trying.

Across sectors, there are many companies awaiting a turn in the cycle – and the only reason they’re still around is due to the good graces of the government. But cycles don’t truly turn until fewer people are around to looking at them, and it’s doubtful policymakers are willing to adopt this position and let liquidations occur. Playing for time comes at a cost – on a personal level, it means delaying decisive action that stands a chance of accomplishing something. I can only imagine what it will mean for the country as a whole.

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One prominent argument used by critics of the government’s actions since September 2008 has been that various programs – TARP, TLGP, etc. – have been used to avoid the reckoning needed to clear bad debts out of the system. For a time, any new risks that emerged were dealt with through creative application of the rules (as with many “bank holding companies”) or, when that failed, by simply creating a new lending facility. The government’s blessing likely saved many marginal institutions, and several larger ones as well.

The policy of saving everything that’s not Lehman looks ready to be put to the test, as CIT Group (CIT) is said to be unable to obtain help from the government. The stock now trades under $2/share, and the credit default swaps are flirting with a 40% up-front premium. For its part, CIT has argued that they provide key financing to small businesses, and should be supported while they work out things on their balance sheet. Without CIT, it continues, these companies might have their credit lines dry up, creating economic ripple effects.

I’m not going to speak in particular about CIT, but about the precedent – one way or another – that it could create. Why should you allow for failure?

The main theme is that profitability moves in cycles. The more competitors in a space, such as lending, the narrower the earnings spreads will be. Want to achieve ROE targets from a quieter era? Add more leverage to your declining ROA. That will do the trick, until the cycle turns and the quality of your loan book starts to raise eyebrows from those who lend to you. The seemingly free lunch from borrow short, lend long has to have periodic shakeouts; it’s what keeps spreads healthy and allows some banks to make profits long-term.

Does government help certain businesses in many ways? Yes, point granted. But should government be responsible for making decisions about one-off bailouts every time a company gets in trouble? Letting a debt-laden company linger when the underlying equity is close to zero, especially by using taxpayer money, is implicitly transferring money to debtholders, as well as granting equity holders increased option value. In other words, private capital wins all around, at the expense of public money. How this is good public policy eludes me.

“Rationalize” is often management-speak for “cut” – but that’s exactly what should happen in a recession. Letting failure happen shows that equity ownership, and debt lending, carries risks. It forces investors to think more carefully about allocating capital, and discourages reaching for high returns. If a company can execute a debt-for-equity swap to recapitalize, that’s great – but it stresses the point that a combination of high returns and safety can’t always be achieved through a full cycle, even at a senior position in the capital structure.

When firms disappear from the competitive landscape, it helps those with strong hands. Taking it a step further, it also impacts those who did business with the failed company. If you happen to be a smaller business, and your lender goes under, what happens to you? If you are a good credit, it shouldn’t be impossible to find another source of credit. Will it be more expensive? Perhaps. But under-pricing risk on the part of your original lender led to their insolvency. The solution to that is to raise the associated costs, so that the lending activity is economic (i.e. value-creating) over a full cycle after appropriately provisioning for credit losses. This might be painful for some marginal borrowers, but it is ultimately what helps the system clear out and reset to one that allows for healthy growth.

Recessions cause pain. Oftentimes it seems unfairly applied, but no good solution has been found. Losses have to be taken at some point, by someone – postponing the process simply leads to silent losses (decreased profits) through the opportunity costs associated with the unreasonably high competition that comes with subsidized businesses. Up to this point, it has seemed that politicians have preferred the delay-and-pray, but a chance to change course has arisen. Hopefully, policymakers will start evaluating the viability of allowing failure to happen naturally across all industries, recognizing the immediately unintuitive outcomes may be in the best long-term interest of the country as a whole.

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