More Pet Projects vs. Recovery

This week Volvo, the world’s second largest truck maker, announced that third quarter net order bookings for new trucks in Europe totaled just 115, down from 41,970 a year earlier, for a decline of 99.7%. Year-on-year orders at Volvo crashed 55% in the third quarter. In Europe it had almost as many cancellations as new orders. The company said that the slowdown appeared to be spreading to emerging markets.

Both the old and new economies are feeling the effects. While the Baltic Dry Index – which tracks prices for shipping bulk cargoes such as iron ore, coal, and grain from producers such as Brazil and Australia to markets in the U.S., Europe, and China – has plunged 86% since May 2008 and steel prices have fallen by 20%-70%, Yahoo!’s shares have fallen from $31 in February 2008 to about $13 today as internet advertising – Yahoo!’s main source of revenue – a slows with the economy.

So is now, as economies enter the throes of a real recessionary downturn, the time for policymakers to continue pursuing pet social experiments? There are many to choose from in the debate and, indeed, some have already won out.

For instance, the banking industry won a huge victory with the expansion of deposit insurance coverage in the U.S., recently. In fact, the industry had been advocating the increase for several years now, having only recently retreated from lobbying when the (pre-Sheila Bair) FDIC announced that increased coverage would carry with it increased deposit insurance premiums. Hence, the industry got just what it wanted when the bailout package increased coverage from $100,000 to $250,000 while strictly prohibiting the FDIC from raising assessments merely because of the increased coverage limits. The political reasoning was because the plan was introduced as “temporary,” but that may only mean temporary until the next increase.

Another example is broadly applied loan modification policy, one of Sheila Bair’s pet projects since before being appointed FDIC Chair. Although the idea sounds attractive in theory, there exists neither hard statistical evidence nor independent studies showing that modification helps borrowers. Available servicer data suggests that recently modified loans show a 20% one-year re-default rate, in line with previous historical performance, but with higher proportions of loans modified before ever entering delinquency. Indeed, modification can easily cross the line into abusive practices that merely squeeze more money out of troubled borrowers before inevitable failure, as evidenced by many Justice Department investigations into fraudulent foreclosure relief programs.

Furthermore, the policies are still motivated by a stated objective of “preventing” foreclosures, in a manner akin to the unabashed “maximization” of home ownership that promoted the housing bubble under the National Homeownership Strategy of 1995. Even the Washington Post this weekend opined that “To be acceptable at all, the [modification plan] must limit relief to a particular set of troubled, low- or moderate-income borrowers who have had their loans for some time.” Of course, such reasonable limitations render modification programs largely irrelevant as a tool to fight the economic crisis because few borrowers will qualify.

Meanwhile, the servicing industry is still sorting out modification winners and losers. While much jawboning has been given to protecting RMBS investor value, the recent Countrywide settlement for allegedly predatory underwriting suggests pushing losses from modification required to address Countrywide’s alleged malfeasance to investors, rather than to Countrywide creditors or its new parent, Bank of America, as might be expected under standard representations and warranties.

Finally, the granddaddy of pet projects, that of Bernanke and Paulson to at one time preempt a recession using tools stronger than those developed to fight the Great Depression while promoting industry consolidation and deregulation under the guise of alleviating the “systemic risk” that only they can detect.

While there are far too numerous pet projects tied up in the current Fed/Treasury approach, some key elements are (1) breaking the remaining walls between investment and commercial banks left in place by Gramm-Leach-Bliley; (2) explicitly promoting banking industry consolidation through the Treasury capital program – consolidation that will increase too-big-to-fail considerations and that pesky “systemic risk,” and; (3) addressing the crisis merely as a targeted “liquidity” problem, ignoring the solvency difficulties at the core of uncertainty about credit extension. In doing so, as Anna Schwartz so eloquently put it in a Wall Street Journal interview the weekend of October 18, Bernanke is fighting the “last war,” in that while liquidity may have been the proximate cause of the Depression, solvency is the greater difficulty in this, aptly named, credit crisis.

In the meantime, unexpected consequences abound. Short-selling restrictions have limited investor information and caused widespread hedge fund failures. As the funds fail, they are forced to liquidate physical holdings, pushing stock prices down and worsening the purported crisis. Subsidized Fed facilities for money market funds, commercial paper, and other investments totaling some $2.2 trillion are substantially disrupting those markets, while proposed investment activities in mortgage-backed securities and related collateralized debt obligations are currently at a halt awaiting both a concrete announcement of form and actual implementation of programs the Treasury will use to allocate some remaining roughly $575 billion (subtracting the $125 billion for the large-bank recapitalizations) in discretionary bailouts.

But while the Federal Reserve, the Treasury, the FDIC, and Wall Street all ponder the “creativity” and pet projects, the economy is beginning to burn. We have only a short time remaining until job losses and real economic slowdown take hold. Better to get on with standard approaches than to continue to debate pet projects and novel experiments. “Creative” financing of homes, businesses, and other investments caused the crisis. More of the same will, at best, postpone losses and, at worst, magnify them.