What is going on here?

Okay, if you caught me on Garland's show the other day then you heard me say that we have partially nationalized our banking industry, and many people aren't even aware of it. So I thought I'd take a couple of minutes to explain in case I was correct.

So last Monday, Secretary Paulson took the extreme step of forcing the nine largest banks in the U.S. to participate in the latest version of the bailout. As I remarked on Thursday, this never would have gotten through Congress due to all of the conservative's that are up for re-election this fall, as it is effectively nationalizing (partially) the banking system. You may have heard that the banks got good terms (this means the U.S. taxpayers got bad terms), that is indisputably correct. [By the way, that link is to an article written by extreme right-wing pseudoeconomist, Don Luskin - the irony is that he is typically screaming (literally) about limited government, laissez-faire, free market capitalism, etc... - here he tips his cap to Hank for stepping up big.]

Regardless, I think I got around to saying that it won't work, but I'm not sure if I actually said those words. I did say that Paulson's approach is flawed because he is doing nothing to separate the good banks from the bad banks. This is not about punishment (though I'm all for punishing those bankers that got us here), but about getting us in a position where our economy is able to move forward.

If you weren't aware, Japan has been dealing with similar issues for the past 15 years or so. One of the key criticisms of the Japanese policy decisions over this time has been that they have left too many bad loans on the books of the banks (it is also generally thought that they did not move quickly enough, nor with large enough fiscal (tax cuts and increased government spending) or monetary (lowering interest rates) stimulus).

Banks that made reckless investments in Mortgage Backed Securities (MBSs) and other financial innovations should be forced to bring them onto their balance sheets and shut down if that means that they are insolvent (meaning they don't have enough assets to pay off all of their liabilities). Paulson didn't even require them to stop paying dividends!

Let's list the reasons why this plan will not work (as outlined this past week, subject to change on a whim):

• Bad banks are still operating - none of the other banks really knows who is a bad bank and who is a good bank. This is a trust issue. Banks want to hold on to as much cash and other safe assets as they can, scared to lend even overnight to other banks because they may not pay them back.
  
• Paulson can force the banks to take the government's money (you may wonder why they wouldn't want the money, I'll discuss below), but he cannot force them to lend. There is some incentive for the banks to do something with the taxpayers money, they are paying 5% on it, but they are far better off paying down higher interest rate debt, or even worse if they are insolvent, "doubling down" on some other very risky assets (they either win big or lose big if they do this, but they are pretty much guaranteed to lose big if they don't).
• Businesses and consumers are rightfully bracing for a recession, possibly a long, dragged out Japanese style recession. Banks may finally come around and be willing to lend, but there needs to be sufficient demand for loans in order for any of this to get the economy going again.
• There is still nothing being done to affect the direction of home prices. Unlike many economists, I do not think that we should encourage government interference in housing markets. Any program that is designed to help people stay in their homes will only extend the pain that our economy is going to go through. It is very simple: you need first-time homebuyers in order to get the housing cycle started again. Anything that keeps housing prices too high, relative to incomes or rents will continue to price out those first-time buyers. Without that core demographic, the rest of us will have trouble finding buyers when we decide to move into a bigger house, or a smaller house (for those entering retirement), or making a geographic move. Anyway, just because I don't agree with it doesn't mean it won't happen, but it's not happening right now. So what? Well, as long as home prices continue to fall (broadly, obviously not everywhere around the country), the value of those MBSs continues to fall and the worse off the banks are that hold those bad assets.

Anyway, I can probably come up with a couple more problems with the plan, but we can sum it up with the idea that even if it works by some miracle, we are still enriching the same Wall St. criminals (at least morally bankrupt, if not outright criminal) that got us into this mess.

And to answer the question I posed above: why would banks not want "cheap" money from the Treasury? Well, good banks (seemingly like Wells Fargo, but I base that upon their response to the idea, not having any inside knowledge of their actual balance sheet) know they are good and don't really need this bailout. They are being forced to participate because Paulson doesn't want to only help the bad banks. Just helping the bad banks would guarantee that they would go bankrupt because there wouldn't be any more uncertainty about who to lend to, no more trust problems. That would be great for the economy (even if there was some short term pain - spike in unemployment, hiccups in the payments system, etc.) because we could focus on how to best move forward, rather than just continuing to put band-aids on the problem.

Very good explanation of "Everything you need to know about the financial crisis"

Posted at the Freakonomics blog. It is a guest post, and they really do cover a lot, if not quite everything - stock markets, the initial plan, the new plan, the problems underlying the market turmoil, and are we heading for a depression?

Shameless self-promotion

I'll be on Garland Robinette's show tomorrow at noon with my colleague, Dr. Jose Bautista.

That's 870 AM, http://www.wwl.com/ if you want to stream on the web.

Fundamental problem with the bailout.

You may have read or heard about the idea of moral hazard in the past few weeks (maybe even right here on this blog).

Moral hazard is the tendency for those that are insured to take on more risk. Big banks were "too big to fail" so they destroyed the financial system by taking on too much risk, knowing that the government (or the Fed) would bail them out if things went bad. Those with a long term perspective won't get caught up in this game, but the short run profits are so huge that many did.

Fannie and Freddie were "implicitly" guaranteed by the government. This allowed them to raise a lot of cheap money to buy up a lot of mortgages and mortgage-backed securities (MBSs). That is how they became so large and it was basically a self-fulfilling prophecy as they were taken over last month. Again, they made a lot of bad decisions - bad for the taxpayer, bad for the long term prospects for themselves, bad for stockholders - because they could get away with it, earning many millions in compensation even while doing their part to destroy the financial system.

There's plenty more on this issue (people that bought too much house, mortgage brokers that profited by selling these horrible mortgage products to people that couldn't possibly understand how they worked, banks that originated and sold the mortgages, etc. - all basically expecting someone else to bail them out when the tide turns), but let me just say that the fundamental problem is not moral hazard. This is part of the explanation of why some people behaved the way they did, but it is not the fundamental issue.

Many alternative plans have been proposed, some sound pretty good, but virtually all are fundamentally flawed because they are just creative (in most cases anyway) ways of reflating the economy (meaning, getting people/companies back to the lending trough). Lending/borrowing just for the sake of increasing consumption cannot be the solution to the problem. That is the problem.

Economists have referred to the past twenty-eight year time period as the great moderation. That is, a time when the economy was generally strong and inflation was generally not a problem. Many feel that we have basically conquered the business cycle, particularly with adept use of monetary policy to control inflation and limit downturns in the economy. This is an illusion built on the expansion of money and credit over this time period.

Everything produced in the United States (overall output, GDP) is categorized into one of the following: Consumption (C), Investment (I), Government spending (G) or Exports (NX - Net exports). Consumption in the U.S. has grown from around 62% of GDP to around 70% of GDP. Think about how much of that consumption growth was driven by access to easy, cheap credit. Consumers are tapped out and the tide is slowly turning. Unfortunately, the economy has to go through a hard recession in order to effect the changes in attitudes that will lead to a stronger economy with some real long-term potential ahead of it. This would have been much easier on everyone if we'd just dealt with the problem 10 or 15 years ago, and that should be the primary lesson coming out of this economic crisis.

I'm going to spend a lot of time refining this line of thinking over the next couple of years. Whether or not you agree with me, your comments on this will be greatly appreciated.

President Bush famously declared that this country was addicted to oil just a couple of years ago. There may be some truth to that assertion, but I contend that this country has a much bigger monkey on it's back with its addiction to credit.

Why didn't they just do this?

Here's something that should actually help.

The Paulson Plan doesn't actually tackle the problem of banks unwilling to lend to one another and/or the related problem of banks hoarding cash. This crisis was supposed to be affecting "Main St." via companies having problems getting financing and having problems paying suppliers, employees, and their creditors. Because credit was getting to be so difficult to get, companies were going to have to make some tough decisions - probably leading to a lot of layoffs.

The Fed is now lending directly to corporations in what is called the commercial paper market. I'll try to post more later. I don't know the answer to the question posed above, but I'll try to give it some more thought.

If you are on the West Bank, I'll be participating in a forum this evening at 6 PM @ The Suite, 3580 Holiday Drive in Algiers (right off Gen. De Gaulle).

Well, let's hope this works

I can't say that I have any confidence in the plan (obviously), but let's hope I've been wrong all this time...

Meet one of the five members of the oversight board on this plan. Two of the others: Ben Bernanke & Hank Paulson. Should be interesting to see how this plays out.

Developing Consensus

I'll try to get some links up on this today, but there's seems to be a developing consensus amongst economists that this bailout won't do what it is intended to do (surprise!) and that we are in for a pretty severe recession regardless of the what happens with the vote today.

The plan ignores (and complicates in some ways) the biggest problem in the credit markets, that is that banks and other financial institutions do not know how much exposure other banks have to the bad assets (MBSs, CDOs, CDSs, etc.) and therefore are not willing to lend to them. Any liquidity (cash/reserves) that they get (by selling assets, from the Federal Reserve, increased deposits) is being hoarded, and this just makes things worse for the entire financial system.

This plan cannot work because part of the current plan is to continue to allow banks to "mark-to-model" - that is keep assets on their books at made-up valuations. This is not going to encourage lending in the short-term credit markets.

A better plan would address this particular issue, because without guaranteeing short-term credit (or providing it directly from the Fed), there will be continuing problems with businesses securing the short-term debt they need to make payroll, pay their suppliers, pay their rent/lease/mortgages or to pay their long-term debtholders. This is how the crisis will impact the rest of the economy.

Very helpful perspective

I say very because it matches my thoughts pretty closely, is easy to follow and is written much better than I can write. Please read this post at Economist's View, linking to an article written by Harvard economist, Ken Rogoff if you are having trouble understanding why I am so opposed to this plan.

It is unlikely to actually solve the problem, and will result in a transfer of wealth to the very same people responsible for this mess.

As an aside, I'll be part of a panel discussion of this crisis at 6pm next Tuesday, Oct. 7 at the Savvy Gourmet (4519 Magazine St. - Upstairs, I think @ Vintage) for those that are local and interested. I have no idea who else will be there, but I think it will be slightly more "mainstream" than my recent appearance on "Our Story." Thanks also for those that have commented and/or sent emails.

Helpful (though somewhat unoriginal) analogy

This story may help put the current financial crisis into perspective.

One more perspective

Here's another comment that makes much more sense to me than the currently debated legislation.

Summary

This comment at Economist's View is a pretty good summary of what I've been trying to say over the past week or so.

Alternatives in brief

I just posted this in the comments on an earlier post, it seems worthy of it's own post:

migou said...

So what, if anything, should be done?

October 1, 2008 7:55 AM

I'll try to get a whole post on this today or tomorrow, but briefly:

I would prefer to see nothing than anything like what's been presented so far. Bankers/traders have made some horrible decisions, seriously underestimating risk (or worse, acting as if they knew they would be bailed out when things went bad). The banking industry (really the entire financial services industry) is too large and needs to get smaller.

Since it's such a large part of our GDP, this means a slow down or recession is inevitable to some degree (it's a matter of how hard and how quickly it's over). Since consumers are over-leveraged, and consumption drives our economy, there's bound to be some contraction in GDP from a slowdown in consumer spending as well.

Anything that props up Wall St. or debt-driven consumer spending cannot be sustained, so these problems will just resurface down the road (or we'll be dragged through a decade-long (or more) slump where things aren't like the Great Depression, but it'll be tough to get a decent job, buy a house, etc.

Politically, it is very unlikely that we'll see this happen. So if something has to be done the focus should be on shoring up the credit markets. This is where businesses are running into trouble with short term financing and what is meant by affecting Main St.

A decent start is here:

Another alternative is here:

I think the second one from itulip is pretty easy to grasp.

Nothing is guaranteed to work (we still have the underlying problem of too much leverage/credit in our system), but the Paulson plan and every derivative of it so far are guaranteed to fail.

They do not address the main issue of banks willingness to lend and business and consumer willingness to borrow. The system cannot function without those two things.

Another provision of the bill voted down on Monday

This is just another really bad component of the legislation that seems to be on the table, we'll have to see the Senate version today.

Mark-to-market accounting.

Unless you work in the world of finance or accounting, this one is probably something that you've never heard of, let alone consider the implications. This post at the Big Picture sums it up pretty well, but the idea is that you need to have an accurate measure of the value of a firm's (including bank's assets. Without that type of accounting, investors and banks will tend to do what they are doing now - refusing to lend or invest. No one knows what the banks' balance sheets really look like because they have not been properly accounting for the MBSs and other assorted risky assets (I will try to get back to explaining the rest (CDOs, CDO-squared, CDSs, etc.) at some point this week.)

Anyway, the plan that went down the other day would have suspended FASB (Financial Accounting Standards Board - they set the rules that accountants in the US need to follow) rule 157. This is the rule that states that these assets need to be marked-to-market. Without that rule, banks are free to mark-to-model and that means we don't know what the assets are truly worth.

This is yet another crucial piece of a bad bill. If these banks are allowed to keep bad assets on the books at whatever value they decide, then investors and other banks will not be willing to invest (the banks need capital - a great solution to this problem would entail lot's of investors stepping in to shore up their balance sheets) and/or lend. That is the reason why we have a credit crunch.

This reminds me of the time that a friend decided to buy tickets to a Patriots playoff game back in the 90s - through a broker - at the time the $200 a ticket (cheap seats) was a pretty steep price. He didn't buy because he was a huge Pats fan, he was speculating. I offered to go to Foxboro with him to help him try to unload the tickets (theoretically for a profit) and bail him out on one ticket for $100 if we couldn't sell them. The market was flooded with scalpers and he was lucky to sell 2 of the 4 for a loss (maybe $150 apiece, can't recall exactly). The point here is that the market decides what the tickets are worth, not you or your friend or me. In his mind those tickets were "worth" at least $200 - that's what's on his balance sheet.

Pretending that they are valued at that price would allow him to borrow more money against those assets (this is a stretch, I'm just trying to tie it back into the current situation) and invest in other assets (MBSs, risky loans, credit card debt, foreign currencies). A better example might be someone that bought a house in the past few years, saw the market prices rising in their neighborhood and took out a line of credit (HELOC) on the house. They booked the value of the house in their mind at that inflated market value. As prices fall, they should mentally write-down the value of their primary asset (the house), but most people cannot do that psychologically. Instead they just think the prices will come back to where they "should" be.

The big difference being argued here is that the banks (amongst others) are suggesting that these assets will be worth more than the market price at some point in the future. This is in fact, the core of Paulson and Bernanke's justification for their approach to solving the problem. Surely all of the MBSs won't be worthless, most people pay their mortgages after all. The problem with that argument is that it could be a very, very long time before these assets "perform" - that is, justify their book (or accounting) value - and many of them won't (are effectively worthless). The lack of transparency is what is causing the uncertainty.

Reasons why this whole thing stinks...

My biggest problem with the plan is the deception. There are obvious reasons to oppose the initial "blank check" plan, but it's not so obvious when Congress is voting on a new, 110 page plan that has supposedly addressed the issues of oversight, executive compensation, and equity participation (partial government ownership - so taxpayers share in any gains in the bailed-out bank stocks).

I mentioned the farce that was proposed as an oversight board in this post. Now consider this statement from Rep. Brad Sherman (D - California):

Paulson has made it clear he will recommend a veto of any bill that contained a clear provision that said if Americans did not own the asset on September 20th that it can't be sold to the Treasury.

Click on that link to Mish's site and read the whole post. This is a pretty big deal, these are words coming from a sitting Congressman, not a blogger (not that I encourage anyone to denounce the words of bloggers). He's basically saying that this was a bailout plan for foreign-debt holders.

Anyway, I had a much bigger post lined up but couldn't put together a cogent argument. There's a lot that is wrong with this whole process and there's reason to believe that any bill that comes up in the next few days will be guaranteed to not solve our problems. The more time that passes the more people are realizing that we've got big problems in our economy that won't be solved by bailing out Wall St. or others that have seriously underestimated risk in their investments. There are options for ensuring that businesses with legitimate credit needs are able to get that credit, and consumers with good credit should have no problem getting more of it. Helping people that bought too much house or that didn't understand their mortgages can and should be addressed on it's own merits.