Posted on 09/26/2008 5:42:27 PM PDT by supercat
In examining the various plans to deal with the financial crisis, there seems to be a common element: a desire to avoid at all cost the collapse of an interlocked collection of derivative securities which could be called the House of CarDS (credit default swaps). The fear is that the massively tangled web of credit default swaps and other derivative securities will explode like a powderkeg that will destroy the economy if things go sour; because of this fear, the collapse must be prevented at all costs.
That attitude is fundamentally wrong and dangerous. First of all, it allows Americans to be held hostage to any demands financial institutions might make. Fail to do as they say, and they'll drop a match. Secondly, the costs of keeping the House of CarDS from collapsing are going to increase exponentially until it does collapse. Since the collapse is inevitable, it would be foolish to spend trillions of dollars postponing it. Thirdly, a collapse of the House of CarDS would not cause a major loss of value in the assets therein; since the loss has already occurred and has simply not been realized, the collapse would simply represent the acknowledgment of the already-existing loss. Fourthly, the biggest factor in today's credit lockup is that nobody knows what any of the paper assets are worth. If the paper assets in one's account are only worth $0.05 on the dollar, it's better to liquidate them and have $0.05 on the dollar of real assets, than to keep pretending the assets are worth face value when everyone knows they're probably worth less but nobody knows how much.
The first point should be self-explanatory. The second point is not so self-explanatory, but it is both observable empirically and explainable theoretically. I'll return to it later. As for the third third point, consider the following analogy: Joe Banker opens up a bank. Individual account holders are limited to depositing $100,000. The first $10,000,000 that people deposit in are shown on display. Any money that's put in after that goes to the vault in the back. What Joe doesn't tell anyone is that he actually pockets 80% of deposits and send them to secret offshore accounts in Fredonia. Each individual account holders can see that the bank has over $10,000,000 in assets, which is clearly enough to pay him off. What the account holders don't see is that the same assets are being used to back many times their worth in deposits, so even though people have deposited a total of $1,000,000,000 in the bank, there are only about $210,000,000 worth of assets backing them up.
Would a run on the bank cause the people to lose money? Not really. A run on the bank would cause the later depositors to lose everything, but the major loss came when Joe pocketed 80% of the deposits and sent them off to Fredonia. While a bank run would arbitrarily redistribute the losses (so those who withdraw early pass their losses off to latecomers), depositors on average will have lost $0.79 on the dollar before the run even started. The only effect of the run will be a fight over the last $0.21.
Returning to the original second point (exponential cost to prop things up), assume that Joe's Bank hasn't crashed yet, but the reserves are getting low (people who deposit money sometimes have the audacity to withdraw it). So Joe decides he needs to get more depositors. Easy solution: offer higher interest rates. In response to the higher rates, more people deposit the money, and Joe keeps getting more and more money to put in his pocket. Each dollar that Joe takes in and then pays out must be replaced by more than $1. Even if Joe weren't pocketing anything, the payment of interest would require an increase in the rate of deposits. If Joe starts pocketing money for himself as well, that will cause things to escalate rapidly.
On to point number four. Suppose that Acme Plastics has recently borrowed a lot of money to purchase another company which, as it happens, had lots of assets of dubious worth. If those assets are worth $0.10 on the dollar, Acme Plastics is solvent. If they're worth less, it's not. Acme Plastics has an assembly line all set up to produce Tickle Me Paulson dolls, and stores are waiting to receive them. All Mr. Acme has to do is get $100,000 of raw plastic on credit and he'll soon have $1,000,000 worth of merchandise. Unfortunately, since potential creditors have no way of knowing whether Acme Plastics is solvent, they have little desire to lend money and risk having to fight other creditors for its return.
If the crash of the House of CarDS revealed the real value of Mr. Acme's dubious assets to be $0.15 on the dollar, the crash would help Acme Plastics get credit, since he could show that his business was solvent. Even if it showed the value of those dubious assets to be only $0.01 on the dollar, though, it could still be a good thing for the Acme Factory. Markets love gains, but they tolerate losses. What they don't like is question marks. If the assets are shown to be worth $0.01 on the dollar, and that is insufficient to meet obligations to existing creditors, there are many ways to keep the factory open. Creditors may accept a debt-for-equity exchange. Or the business could be liquidated with the factory, intact, bought out by someone who could then supply the raw plastics needed to begin production. Even if none of those desirable things happened and Acme Plastics was disbanded, that wouldn't be much worse than having the company go broke because it couldn't get the credit needed to produce products.
So what do all these points mean? The fundamental danger in today's marketplace is not that there will be a crash, but rather people will act irrationally in an effort to avoid one. Nobody is going to want to see his portfolio drop by $0.50 on the dollar overnight, but throwing in good money after bad in an effort to deny reality is no solution. A lot of the money put into the markets by investors is gone. No amount of hope or optimism will change that. The only way to restore confidence in the markets is to find how much money is gone and how much remains, and then move forward.
“SEC. 132. AUTHORITY TO SUSPEND MARK-TO-MARKET ACCOUNTING.
(a) AUTHORITY.—The Securities and Exchange Commission shall have the authority under the securities laws
(as such term is defined in section 3(a)(47) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47)) to suspend, by rule, regulation, or order, the application of
Statement Number 157 of the Financial Accounting
Standards Board for any issuer (as such term is defined
in section 3(a)(8) of such Act) or with respect to any class
or category of transaction if the Commission determines
that is necessary or appropriate in the public interest and
is consistent with the protection of investors. “
This would create havoc in the markets if they do this because it would directly affect a ton of CDS contracts. It's basically 'lose if you win and lose if you lose'.
The economy will not outright fail if we allow the market to go it's natural way. It is when we artificially prop up the weak links that we endanger the citizens in the long term.
The only interference we need is to eliminate the obviously too loose credit rules for borrowers. Large and small.
Start at the base with the little stuff and the large stuff will fall in line.
Also make the executives of large financing liable for performance. When their livelihood is on the line like every citizen with a job (except government employees) is subject to.
Start with the small stuff, apply rules equally, and the large stuff will fall in to line.
We do NOT need the government to bail out businesses for self created problems. That is so anti-capitalistic and not at all what the founders wanted to be involved in.
Many types of qualitative predictions and judgments in economics can be made without any special expertise. One doesn't have to have a PhD to realize that if something that's worth $100,000 is divided into 1,000 shares, the shares can't be worth $1,000 each no matter what the market price for them happens to be, nor to understand that a sudden drop of share price to $100 would not represent any real loss of wealth.
If you dispute any of my reasoning, kindly explain your specific objections. I've tried to be simple and straightforward, but I may have missed something.
Only the US Government had enough power to cause this problem. Witness the CRA.
Only the US Government has deep enough pockets to clear the markets of these “toxic assets” and get credit markets moving again.
Only the US Government has deep enough pockets to hold the “toxic assets” long enough to determine which deserve the label toxic and which can recover in value.
“Let the markets sort it out” rings flat somehow when one realizes that it was a violent distortion of the market (the sub-prime mandates of the CRA) that started this problem.
I will refer you to the Resolution Trust Corporation as a model.
I will refer you to the Resolution Trust Corporation as a model.
I see no way for any of that to work unless the government forcibly consolidates the mortgages that comprise MBS's. If the government will not do so, then it's guaranteed to pay too much to buy those assets, since the last shareholder of a tranche to sell will have the power to prevent the government from holding any of the mortgages free and clear. If forcible consolidation is allowed, I would think that allowing it to be done privately (e.g. allow shareholders whose shares of a tranche add up to at least one whole mortgage to exchange a mortgage worth of shares for a mortgage selected at random from the tranche (the exchanged shares would be divvied up among the other shareholders, so that instead of e.g. 100 people each holding 1/100 of 100 mortgages, there would be one person holding a whole mortgage and 99 holding 1/99 shares of 99 mortgages.
If the shares are divided up differently, things may be a little more complicated, but there shouldn't be any fundamental problem. For example, if there are 20 mortgages divided 30 ways, then a person would have to get two shares to consolidate. Prior to consolidation, each share would hold 1/30 of 20 mortgages; the two shares being consolidated would together hold 1/15 of 20 mortgages, i.e. (1/20 + 1/60) of 20 mortgages. After consolidation, every 1/30 share of a property would become 2/57 and the 1/60 shares would become 1/57. So one person would hold a loose mortgage and 1/57 shares of 19 properties, while everyone else would hold 2/57 shares of 19 properties.
If the distribution were done by a clean provably random method (possibly a published pseudo-random generator seeded by state lottery drawings), there shouldn't be any problems with fraudulent valuations. Someone who asked to consolidate his shares might get a good mortgage or might get a worthless mortgage for a house that was never even built, but the probabilistic expected value would be the same as the average value in the tranche. There would be no cherry-picking allowed, but holders of a dubious tranche might still decide that a 10% chance of getting something good outweighed the 100% chance of having a piece of paper that nobody wanted.
BS! I'm in the market now and people that can't afford the loan don't get the loan. Good Grief. Grow up and know how PC damaged America. There is plenty of money.
What a typically ignorant response.
If you don’t see something, hear something, experience something, then it must NOT exist.
Okay then! Have a nice time.....in the market. Whatever that means.
P.S. Don’t bother to tell me! Because by your reasoning, if I’m not in the market, then the market doesn’t exist.
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