Posted on 09/19/2008 8:27:07 PM PDT by B-Chan
It’s helpful to think of how to address the current financial crisis (and I don’t use that word casually) in terms of the end-state we want to achieve, and the transition plan to get there.
The problem we face is often described as mind-bendingly complex, but in its essentials, it is simple.
It is well known, in retrospect, that we had a classic speculative bubble in home prices. As is typical in a bubble, its later stages were characterized by reckless investment, excess debt and shady-tending-to-illegal business practices. As cheap credit pushed up the market price of houses, homeowners began to incur lots of debt (i.e., promises to pay other people on Tuesday for a hamburger today), which they were comfortable doing because they believed that they had sufficient equity value in their homes to make good on the debt if required. Some of this debt was mortgage debt. Many people who previously would not have received mortgages got them. Simultaneously, many homeowners were offered and accepted mortgages that approached all-debt at floating interest rates, rather than the traditional 20% down 30-year fixed rate mortgage. In the worst instances, these mortgages had payments that were all-but-certain to rise in the future. These homeowners were betting that they would get raises, inherit money, or, more likely, would be bailed out by an increasing home price that would allow them to roll over the debt. Other debt was incurred by existing homeowners for the purpose of consumer expenditures, which had the net effect of hollowing out the equity they had in their homes. All these effects are just examples of greater levels of debt secured against the market prices of homes.
Here’s the problem with having lots and lots of debt and no savings, whether in the form of passbook savings or equity in your house: Sooner or later Tuesday comes around when you happen to have had a bad week, and the guy who sold you your hamburger wants his money, but you don’t have it. Once home prices began to decline (or for the most over-leveraged homeowners, simply stopped rising fast enough), therefore, it was a big problem when Tuesday started to come around and lenders and vendors started to ask to get paid for the hamburgers.
Normally this would have been bad for both the homeowner and the guy who wanted to get paid for his hamburger, which might very well be the mortgage lender, but not really a big deal for you or me. (If enough of this occurred, of course, it could lead to a general slowdown and hurt pretty much everybody.) But this impact was magnified by the fact that most of the mortgage lenders sold the right to the payments under the mortgage to third parties. These third parties broke up the rights to the payments from the mortgages into lots of little pieces, combined these pieces with the rights to payments for little pieces of lots of other mortgages, repacked these in “creative” ways, and re-sold them to fourth, fifth and sixth parties. Four, five and six then used these promises as their own equity in order to raise further debt of their own. This would be like you using an IOU from your neighbor as your down payment for a mortgage. So when lots of these over-leveraged homeowners started to miss mortgage payments, parties four, five and six had less money than they expected, and they had problems making their own debt payments if they themselves had taken out enough debt. Oh yeah, many of these debt contracts are in fact between parties four, five and six.
Unfortunately for you and me, parties four, five and six are the financial institutions where we have our life savings deposited.
The end state that we want to get to is pretty clear.
The price of the average home in America has fallen a lot, and is likely to fall further (although there will be huge regional differences). Some very over-leveraged homeowners are going to declare bankruptcy. Others are going to sell the boat and eat out less in order to avoid this. We need prices to mark to market (which they will eventually do anyway), as rapidly as possible consistent with not causing a depression caused by a collapse of consumer activity.
Many financial institutions have both profitable commercial businesses, and financial instruments that are wildly unprofitable, housed under one roof. We want the executives of these companies to lose their jobs, and the shareholders and bondholders in them to lose their money, while preserving the productive parts of the businesses and preventing a depression caused by a collapse of credit.
The trick, of course, is how we get these excesses purged from the system without tanking the economy worse than anything we have seen at least since the 1930s. What makes this especially tricky is that we don’t have a lot of visibility into how exposed each of parties four, five and six are to collapse.
This is what Paulson and Bernanke are trying to manage. They have done three big things in the past couple of days:
1. Proposed a huge RTC-like government “bad bank” that banks can dump all their bad loans into. (Apparently, though, unlike the case with the RTC, they will not need to declare bankruptcy to do it.)
2. Provided a federal guarantee on money-market accounts.
3. Promulgated a temporary ban on naked shortselling for about 800 financial stocks (in related news, the new recommended medical practice when you discover that you have a fever is to smash the thermometer against the wall, since this makes the problem go away).
All of these things are, in theory, bad. In practice, all will have very negative consequences over time. Here are some of the problems:
1. We’re getting pretty close to nationalizing (hopefully temporarily) a reasonably big piece of the U.S. housing finance market, as well as other financial sectors that are put at risk by it.
2. Time will tell, but likely medium-term implications include higher government interest payments, worse deficits and higher taxes. This certainly reduces the probability of making the Bush tax cuts permanent in a couple of years, no matter who is in the White House.
3. This is obviously unfair. It bails out irresponsible behavior, and by implication, punishes responsible behavior. Longer-term, unless there is a lot of pain felt by financial company executives — who, remember, don’t look like they have to go bankrupt to dump their bad loans on taxpayers — this creates a massive moral hazard problem. Further, if such a situation develops, it won’t be lost on voters, who will likely demand greater socialization of consequences of reasonably-foreseeable bad behavior by people who don’t make a million dollars per year. The ideological consequences of the last few weeks will take many years to play out, and conservatives are unlikely to happy about them.
4. It’s also unclear how much of the problem, and what problem, this really solves until home prices hit bottom. As the market price of the underlying assets keeps dropping, more and more debt instruments become “bad,” with cascading effects. Though not likely, it is a lot more plausible than it was five days ago that the federal government may become a buyer of the actual housing assets. In that case, welcome to the introduction of large-scale public housing for middle-class Americans.
These all sit on one side of the scale. Against all of this we have one huge consideration. If investors lose confidence in the safety of money market funds, mutual funds, demand deposit accounts and the other storehouses of value in the modern economy, we would have a problem that would make somewhat higher taxes and moral hazard seem like child’s play. Trust me — you do not want to experience a full-scale bank run in contemporary America. I’m not sure how many people realize how close we were to the wheels coming off at about noon yesterday, as major commercial-paper processing banks like State Street lost 30% – 60% of their value in about 2 hours. Want evidence: When was the last time you heard of the U.S. government identifying a problem, developing a multi-hundred-billion-dollar program and announcing it within about 48 hours?
It seems to me that these are prudent actions as temporary, emergency measures. What will be essential is that:
1. These are temporary, and these positions be unwound as rapidly as possible. This includes not just the actions of the past two days, but also getting the federal government out of the insurance business (AIG) and the home lending business (Freddie and Fannie) as rapidly as is consistent with orderly unwinding of these positions.
2. The ultimate resolution assures that prior investors in these financial institutions and their executives bear very large financial penalties. Irresponsible homeowners should as well. Expect big political battles over the definition of “irresponsible.”
If done in this way, we can (in the hopeful case) work through the problem with limited actual costs to the taxpayers as assets are sold off, while limiting moral hazard and long-run government control of financial assets. But there are many very bad downside cases.
It also sounds like some California (and Nevada and Florida) house prices are perhaps three or four times (down from five or six times) what they should be.
I guess that's better than some bad neighborhoods in Detroit, where you can buy a so-called home for $50, negotiable.
This does not fix the problem of the hundreds of trillions of dollars of outstanding derivatives (CDS) outstanding. It only fixes (well, tries to fix) the primary market on which those CDS's are based, the U.S. mortgage market.
Here is Mish's comment:
The idea behind the above statement is to allow for a continual dumping ground such that there will always be $700 billion in toxic garbage held under this program. As soon as any asset can be unloaded by the Treasury at cost, another toxic loan is eligible to be assumed on the books of the Treasury. This process can last for as long as two years.
It's time to Weep For The Free Market (or rather what little free market the US had left).
At taxpayer expense, Bernanke and Paulson are willing to bail out their banking buddies at enormous expense to the average taxpayer of this country. Bernanke and Paulson should both should be fired. Instead Congressional sheep will baa yes to this bailout and Bush will baa yes when he signs it. It is a sickeningly sad that day for America that Congress will go along with this proposal that makes the US Taxpayer A Giant Dumpster For Illiquid Assets.
$700 billion will be wasted by this program and it is $700 billion the US does not have to waste. I ask that everyone vote against any congressman who votes for the passage of this bill.
I live in Champaign, Il. There is plenty of farm land around. You can go out and build a 3 bedroom home with an unfinished basement for ~$200K in one of the nearby bedroom communities.
All those terrible things are going to happen anyway. We've just kicked the can far enough down the road to last until the election is over.
What we're seeing here, I believe, is the "Banker Consolidation Act of 2008". For most banks to sell their bad mortgage paper to this new Rescue Bank (or whatever it's called) the bank will have to mark the asset to market value. That will bankrupt perhaps a thousand banks.
The big banks hate competition. Now and then, they drive out all the little competitors. This happened in the 1930's, in the Savings & Loan crisis, and now.
The few favored big banks, such as JPMorgan Chase, will be able to pick up the failed banks, minus their toxic waste. This will strengthen the balance sheets of the surviving banks.
We saw the rehearsal of this with Bear Stearns. The Feds got the toxic waste (guaranteeing $30 Billion of it) and JPMorgan got the rest of it.
Not all this was a grand plot. Much of it, such as some of the growth in hedge funds and unregulated complex derivatives that only a computer program could understand, is just plain greed, writ large. Nothing new there, except the Bigger Font used this time (more zeros before the decimal point.)
And some of this will conveniently play into the larger, looming crisis of Social Security, Medicare and Medicaid, whose unfunded liabilities dwarf this current bailout by nearly a 100 times! The only way out of that mess, short of national default or the widespread breakdown of society (and the Second American Revolution) will be inflation. We are off to a great start on this round of inflation with the current bailouts.
Over the next decade, I'm betting on inflation reducing the value of a dollar by perhaps 10 percent per year. Some years, inflation may peak at 20% or 30%.
When the foreign countries (China, Russia, Saudi Arabia, Japan) holding vast piles of dollars and Treasuries decide to send that paper back home, to us, it could get painful. The dollar will cease being the world's currency, and weaken further relative to some other currencies. This will continue to unfold (China has already stopped growing its dollar reserves) over the next few years.
Shorter term (next year or three) I'm betting that we continue in a bear market, with significant bear market rallies. We likely entered a bear market rally on Thursday this week, through the first month or two of 2009 (though it will have its ups and downs.)
We will be in a serious recession, with rising unemployment, for the first couple years of the next Presidential term.
The survivors of this financial crisis will include JPMorgan Chase and Goldman Sachs (whose former CEO Henry Paulson is now conveniently running Treasury, for a few more months.)
The survivors will also include many small banks that minded their P's and Q's (Pints and Quarts -- old nautical term) and present no threat, nor much of a target, to the fat cats.
When Warren Buffet commented that derivatives were weapons of mass destruction, he was right. These weapons are now being used, as we speak, by the fat cats against their doomed competitors.
I think that the fat cats honestly do want to pull off this theft of vital body organs without killing the host (our country ;). So far, they seem to be succeeding.
However, free market capitalism, personal liberty and respect for our Constitution are not high on their list of priorities.
Needless to say, there is little risk of that ;).
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