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.
AS I PASS through my incarnations in every age and race,
I make my proper prostrations to the Gods of the Market Place.
Peering through reverent fingers I watch them flourish and fall,
And the Gods of the Copybook Headings, I notice, outlast them all.
We were living in trees when they met us. They showed us each in turn
That Water would certainly wet us, as Fire would certainly burn:
But we found them lacking in Uplift, Vision and Breadth of Mind,
So we left them to teach the Gorillas while we followed the March of Mankind.
We moved as the Spirit listed. They never altered their pace,
Being neither cloud nor wind-borne like the Gods of the Market Place,
But they always caught up with our progress, and presently word would come
That a tribe had been wiped off its icefield, or the lights had gone out in Rome.
With the Hopes that our World is built on they were utterly out of touch,
They denied that the Moon was Stilton; they denied she was even Dutch;
They denied that Wishes were Horses; they denied that a Pig had Wings;
So we worshipped the Gods of the Market Who promised these beautiful things.
When the Cambrian measures were forming, They promised perpetual peace.
They swore, if we gave them our weapons, that the wars of the tribes would cease.
But when we disarmed They sold us and delivered us bound to our foe,
And the Gods of the Copybook Headings said: "Stick to the Devil you know."
On the first Feminian Sandstones we were promised the Fuller Life
(Which started by loving our neighbour and ended by loving his wife)
Till our women had no more children and the men lost reason and faith,
And the Gods of the Copybook Headings said: "The Wages of Sin is Death."
In the Carboniferous Epoch we were promised abundance for all,
By robbing selected Peter to pay for collective Paul;
But, though we had plenty of money, there was nothing our money could buy,
And the Gods of the Copybook Headings said: "If you don't work you die."
Then the Gods of the Market tumbled, and their smooth-tongued wizards withdrew
And the hearts of the meanest were humbled and began to believe it was true
That All is not Gold that Glitters, and Two and Two make Four
And the Gods of the Copybook Headings limped up to explain it once more.
As it will be in the future, it was at the birth of Man
There are only four things certain since Social Progress began.
That the Dog returns to his Vomit and the Sow returns to her Mire,
And the burnt Fool's bandaged finger goes wabbling back to the Fire;
And that after this is accomplished, and the brave new world begins
When all men are paid for existing and no man must pay for his sins,
As surely as Water will wet us, as surely as Fire will bum,
The Gods of the Copybook Headings will with terror and slaughter return!
“The stock market strode out from under the shadow of a panic in call money that so lately threatened, revived in all its old strength yesterday. Assured that the New York banks were ready with their boundless resources to prevent a money crisis, the public and the professional trader set out to repair the damage done to prices on Monday and the major part of Tuesday. Stocks in the aggregate, though bucking a 15 per cent rate for loans, enjoyed the greatest advance they have known in a single day in the last two years. Not even the surging bull markets of the memorable year 1928 saw such a day of heavy buying.”
—New York Herald Tribune, March 28, 1929
“Several brokerage houses tumbled; blue-sky investment companies formed during the happy bull market days went to smash, disclosing miserable tales of rascality; over a thousand banks caved in during 1930, as a result of marking down both of real estate and of securities; and in December occurred the largest bank failure in American financial history, the fall of the ill-named Bank of the United States in New York.”
—Only Yesterday: An Informal History of the 1920’s by Fredrick Lewis Allen
And a bureaucracy that will not go away. We are all socialists now.
1. These are temporary, and these positions be unwound as rapidly as possible.
I don't believe it will happen. But perhaps someone can point out an example of a return to free-market principles, once the socialist genie is out of the bottle?
While it may be impolitic to say so, we need to take the hit manfully and without all the bellyaching. It's a part of capitalism.
So I have a question. If the gov’t is going to guarantee money market accounts and the current short term treasury note is yielding zero (or less) won’t aggressive MM managers just start buying riskier investments since any losses are guaranteed? If you don’t go the riskier route you get no business. Same deal, different market.
The USA is now like a person who can’t pay there Bills so they turn to putting everything on a credit card. At the same time there income is dropping. Sooner or later they won’t be able to pay the credit card bill. Or the card issuer will cancel the card. They will either have to cut back to bare minimum including stopping the payment of all entitlements(SS,Medicare,ect...) or they will default. The interest on the Debt will eat up most of the tax revenue. That is the position the US is putting itself in now.
No problem here. I never financed a hamburger.
The only justification for using fiat money is to increase supply during an expansion to avoid choking-it off (and all the crap that comes with the self-induced implosion).
Think of it in terms of driving: From a dead stop, you apply the gas (money throttle) to get up to speed. After you hit cruising speed, you let off (the money throttle). The engine (economy) will hum along steadily until you get to a hill- where more 'throttle' will be necessary. Once over the hill, everything is downhill and you could put it in neutral, turn off the iginition, and glide the entire way- if you wanted.
What the fed did (the driver of the bus, if you will) was keep the throttle down as we went over the top and what a ride it was to the bottom. So, now we find ourselves on our side and there are a few casualties who are just now being attented to by our government (taxpayers).
The tow trucks will right the bus and the ambulances will take Lehman, Bear, Fannie Freddie, and AIG to the hospital. Not all will survive, unfortunately.
Now, what's it gonna take to get the rest of you back on the bus to finish the trip? A bribe? Well then, try this: you don't get back on, you don't get home. And if you don't make it home, your kids will be saying things like, "My parents are stupid hippies!" "I can't take it anymore." "Gosh!"
Cool poem.
But you would not let your child run in front of a speeding truck, just to "teach them a lesson."
If they had let this financial collapse occur without such extraordinary measures to abort it, then all the dollars and Treasuries (trillions of dollars worth) overseas would have become nearly worthless within weeks. The dollar is the international currency, and has been since World War II. Trillions of dollars and Treasuries sit overseas, as we have overspent and over borrowed for decades.
Most commerce with other nations would have ceased, other than perhaps a little tourism, with other nationals (if their nations hadn't collapsed too) visiting us like we (used to) visit third world countries. That 70 percent or whatever of our energy we import, and major portions of other valued imports, would have pretty much ceased.
Our troops would have all been called home, because we could not afford them, and we needed them to keep the peace at home.
Our ability to sell Treasuries, which we are doing by the billions and trillions, would have ceased, overnight. The only way the government would have to buy anything would be with rampantly inflating dollars, similar to the Wiemar Republic in Germany or Zimbabwe.
Essentially all banks, all businesses relying on banks, all major commerce would have ceased.
Most of us would be unable to feed ourselves.
This leads to riots and loss of social order in most of the cities, within weeks.
I don't think you want to go there.
And in some areas, such as Southern California, it's not 2% or 3%. Half the mortgages let out in the last three years in Southern California are in distress (payments over 60 days late or the mortgage is greater than the current value of the house, or worse), if I am remembering correctly.
Any money flowing into the banks will not go to building more homes; there is no money there. That money will go into shoring up the balance sheets of the bank.
I am still amazed at LA housing prices. There are homes selling now for $400K that I wouldn't give $75K for here in central Illinois. If I wanted to live in a LA, I would have to double my current income. The weather is nice in LA, but not that nice..
$115K doesn't buy much house here in central Illinois. It will get you a roof over your head with 3 bedrooms in a marginal neighborhood.
Then sell the bad debt to collector's and move on. Let them go after the people who owe the money.
Still, a heck of a lot less money than California.
There is no "collector", because there is no underlying marketable asset.
One pretty readable explanation is available at It's the Derivatives, Stupid! Ellen Brown – Web of Deceit September 18, 2008.
Credit Default Swaps (CDS's) are just bets between various banks and hedge funds. Like bets on sport games with your brother-in-law, they are entirely unregulated. If the counter-party (your brother-in-law, or JPMorgan Chase in the CDS case) doesn't or can't pay up, they are instantly worthless.
There is a tangled web of them, built up over just the last decade or so, that is now vastly larger than the banks and hedge funds doing the betting. If some outfit such as AIG, which has played heavily in this CDS game, defaulted on their bets, then basically every bank would be bankrupt overnight, and every hedge fund panic selling any securities they hold, causing a stock market crash greater than 1929 or 1987. And that (financially) bloody day might well be "the best day of the rest of our lives" ... that is, it might well be downhill from there.
A huge number of these CDS's are bets on Fannie and Freddie paper, so if those two went down, even if they weren't into CDS's themselves that much, the house of cards collapses. ... Like I said, they can't sell the bad debt to the collector. The bad debt would have no collector and zero value. It's not really debt, actually. Debt might an underlying collateral that can be attached.
This is more like fifty drunk and rowdy men going into the sports bar on Super Bowl Sunday, each one making massive (a hundred times more than the value of their life savings) bets on the outcome of the game, and each thinking they are safe, because they bet both sides of the game equally.
If just one man in that bar reneges, then a bar room brawl breaks out, and the bets collapse. That's no so bad in the bar; everyone takes another shot of whiskey, punches the man standing next to them, and walks out ... or is carried out.
But the banks in this fiasco are -required- by recently introduced law to mark down their assets to current market value, and they are required by long standing law to have balance sheets with sufficient reserves to cover their (highly, 30 or 50 to one in the case of the five big investment banks ... well now two big investment banks ... only Morgan Stanley and Goldman Sachs are left standing) leveraged loans. The center of the world's financial system, the creator of the U.S. Dollar (since 1913, when the consortium of private banks known as the Federal Reserve was granted a monopoly on creating our dollars) and the creator of the worlds standard currency go "poof".
... and Morgan Stanley is desperately shopping for a buyer, with reliable reports that their CEO has told other CEO's this last week that Morgan cannot survive independently.
That bar room brawl, that massive financial collapse, had already begun, early last week. It was visible on the stock screens, showing once in a lifetime shifts in short term Treasury rates (down to 0.03 %, off the peg of 2.00 %) and LIBOR (London interbank lending rate) jumping sky high, in the space of minutes.
Paulson and Bernanke were (are) applying the defillibrator to the American, and world's financial system, as it had started a massive coronary collapse.
The defillibrator is not the problem. That we had allowed our financial system to become the equivalent of the world's fattest man is the problem.
Even if we determine later that it was a defective defillibrator, causing serious long term damage to our health, it's still not the problem, this week.
$150K gets you a little better neighborhood, which is about average for our area.
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