Fix the Credit Problem, Not its Symptoms
Two weeks ago Monday, markets traded down 300 points at the open. The sell-off seemed to be in anticipation of what was widely considered to be a poorly thought-out bailout plan. As it became clear that the $700 billion package was not going to be approved by the House, the Dow Jones Industrial Average plummeted another 500 points. Stock jockeys had apparently decided that a bad bailout would have been better than none.
Fast-forward to the end of last week: During Friday’s House vote, the Dow rallied 300 points . . . but once the bill passed, they promptly reversed and sold off. It’s been more or less straight down ever since. Since the highs of October 2007 one year ago, the Dow has lost 39%, or about 5,500 points.
How did this happen? Why are markets reacting so negatively to a near $1 trillion bailout? The short answer is that the Federal Reserve and the Treasury Department have been focusing on the wrong issues. They have been treating falling asset prices—houses, stocks, bonds—as well as the lack of confidence between banks, as the actual issue. This is the wrong approach. Falling asset prices and a lack of confidence are a result of the underlying problem. You don’t cure alcoholism by getting rid of a hangover; you cannot resolve confidence issues by merely cutting rates.
The primary problem is that banks are refusing to extend credit to each other. Why? Because they do not understand the liabilities of their counterparties. Translated into English, that means they don’t know if the other bank whom they are dealing with will still to be standing tomorrow.
The thing roiling markets today is not the lack of confidence; It is capital, or more accurately, the lack thereof. Thanks to a series of very poor trades—excessively leveraged and absurdly risky to boot—banks are now dramatically undercapitalized.
As we have seen in just about every historical financial crisis, the shortage of capital is the underlying cause of monetary mayhem. Too much debt, too little equity, makes any financial system cease to function.
Why is that? Consider the way fractional banking works. Depositors
open accounts with banks, earning interest, along with ready access to
their accounts at any branch or ATM. The bank leaves a small fraction
of the money on deposit, and uses the rest for loans, either to
businesses or consumers. The smaller the fraction retained on deposit
by the banks, the more money they have to lend out, and in theory, the
greater their potential profits.
This is a quaint, 18th-century system. It worked well—at least
before the modern era of derivatives and excess leverage. In ye olden
days, a bank would get a $10 deposit, keep a buck as reserve cash, and
lend out the other nine. Assuming they were careful about who they made
loans to, this was a profitable enterprise.
In recent years, banks ran into three kinds of trouble: They made
loans to people who failed to repay them; they did not keep adequate
capital on reserve; they compounded their problems by borrowing money
from each other to buy back all of those loans after they had been
repackaged as fancy securities.
If it sounds ridiculous, it is only because it was.
What makes the current crisis so dangerous is that all these complex
financial maneuvers have left the institutions themselves shell
shocked. They no longer know who to trust. When Banks cannot tell if
the other bank across the street has enough money to survive through
tomorrow, they cease credit operations. As long as this condition
exists, banks will be reluctant to lend money to anyone but the
strongest financial institutions, who of course, do not need it.
Hence, a credit freeze.
Under these circumstances, the original Paulson rescue plan is
unlikely to accomplish much. Buying up risky assets from the banks,
which is what Troubled Asset Relief Program (TARP) is set to do, is
like slapping a coat of paint on a house infested with termites. It may
pretty up the banks for a short period of time, but it is unlikely to
solve the underlying problem.
So what would solve it? The first step to accomplish this is triage.
Identify the banks that cannot survive, and like Old Yeller, "gently" put
them down. Euthanize the bad ones so the good ones can survive.
Nationalize ’em, sell their accounts to strong banks, and prevent
further liabilities to the FDIC (which insures all accounts up to
$250,000).
Next, recapitalize the banks that can survive by buying preferred
stock. That is what Warren Buffett did with General Electric and
Goldman Sachs when he made his investments. The Treasury should
announce a matching program, where any private investment into a Bank
is matched by the government, dollar for dollar, and on the same terms.
This fixes not merely a balance sheet issue (like TARP does) but the
actual capital structure at the root of the current crisis. And it does
so on terms that are good for the taxpayers too.
As this process eliminates the bad banks and recapitalizes the good
banks, normal lending will resume. Defaults and insolvency will no
longer paralyze the financial industry. This is how Sweden resolved its
financial crisis in the nineties, and how England just started to
address their problem this past week.
The good news is that the US is that there are signs the US is
starting to move towards the Swedish / British / Buffett model. The bad
news is that it has taken this long to even begin contemplating this.
We are a year late, a few trillion dollars short. And, its too late
for firms that could have been saved had there been clear eyed
leadership in Washington, instead of mindless cheerleading. As recently
as a few months ago, we were being told thast the economy was sound,
the problem was contained, the dangers minimal. Instead, a parade of
firms such as Bear Stearns and Lehman Brothers and AIG and Fannie Mae
and Washington Mutual and Freddie Mac and Wachovia and Merrill Lynch
are now lost. That is going to have lasting repercussions for the
national economy, and it is going to be felt especially hard in places
like New York City, Connecticut and California.
It might be glib to say “Better late than never.” But that fails to
capture the lasting economic damage caused by missing this opportunity
for so long.
To give you an idea of how costly this delay has been, consider the
S&P 500 financial sector index. It is comprised of over 80 of the
biggest banks, brokers and insurers in the United States. At its peak
in February 2007, it was worth almost $3 trillion dollars. Since then,
it has since declined 56.5%, losing over $1.7 trillion dollars in
value. And that is just one index, and not the entire US financial
sector.
When banks know their counterparties are not in danger of going
belly up tomorrow, they will begin lending again. Confidence will
return once the underlying problem is resolved, and not a minute before.
October 10th, 2008 at 7:44 am
Insightful. How is the labor market for this kind of expertise so inefficient and/or the political market for votes so twisted that this kind of remedy doesn’t occur?
October 10th, 2008 at 7:45 am
BR,
I think they all know, as well, that every usual partner from their normal line of business is exactly in the same boat because they were doing the same dam thing all along. It is not only mistrust, but also first hand direct confirmed knowledge that is amplifying the issues above.
October 10th, 2008 at 7:48 am
I agree, this is insightful. But I don’t think you could have mustered the political will to inject taxpayer money into these financial institutions until we reached the point of full-blown, obvious, undeniable disaster. Let’s just make sure we get it right now that we’re here.
October 10th, 2008 at 7:48 am
The SUN is shining. Have a good day!
October 10th, 2008 at 7:53 am
“As we have seen in just about every historical financial crisis, the shortage of capital is the underlying cause of monetary mayhem. Too much debt, too little equity, makes any financial system cease to function.”–BR
funny that this: “the shortage of capital is the underlying cause of monetary mayhem.” is the flip-side of the Leverage/Financial *ngineering ethos that has been pouring out of ‘B-Skools’ for the last 30 years.
It, and its JIT compadre, has left our Corporate structures, and their Distro systems, Economically, reed-thin.
Even Mae West knew, ‘That ain’t no way to Run a *horehouse’
October 10th, 2008 at 8:00 am
Barry,
There are two major flaws in you arguement:
1. It makes sense: Government does not do what makes sense, it is in the nature of government to first create a new self-perpetuating bureaucracy and then waste an enormous amount of money.
Then, the government will enact legislation to fix the problem that already fixed itself two years ago.
Then the government will spend more money to fix the problem that it failed to fix with the first enormous amount of money but which has already been fixed by this time by the markets.
Then, the government will hold hearings to assign blame for its own failures.
2. Old Yeller was NOT “gently” put down. He was shot. But, you are right, at least he didn’t suffer. [BR: That was sarcasm!]
It absolutely amazes me how the government plan revolvess around solutions created by the same people who caused the problem and generally involves no ideas from anybody that had the foresight to see it coming. How often does the Doctor who removed the wrong Kidney get rehired to remove the right one?
October 10th, 2008 at 8:03 am
BR, you forgot the part where TRANSPARENCY needs to return to the system. Everyone needs to know who holds what cards in the game. No more off-balance-sheet entities! No more unregulated CDS’s.
It’s going to take our government growing a spine to get this fixed. Think that’ll happen before end of year?
Still in mostly cash. The markets will keep dropping until risk is properly priced in. Only way to lower that risk is transparency and a level playing field.
October 10th, 2008 at 8:07 am
Forgot to address one small thing:
The housing bubble
October 10th, 2008 at 8:08 am
Well put, as usual. It is such a shame that congress is not incentivized to do this. Too much lobby $$$ is flowing into senate and congressional coffers in the name of executive friendly solutions that the correct solution remains far out of reach.
It will take the complete collapse of the affected banks to stop this feedback loop.
Look at how many years effective lobby kept Fannie & Freddie from facing the music.
October 10th, 2008 at 8:13 am
Barry is like so many other money managers with blogs – a true “know it all.” The whole point of TARP was to free up more capital and credit. It was a good step but more obviously needs to be done.
October 10th, 2008 at 8:16 am
This argument misses the point that the financial services industry is a big bloated cancer that needs to be eliminated from the society.
In fact, I think it was here on The Big Picture that I saw the information posted.
Back in the 1970s, before all this neoliberal insanity began, the financial services sector (if I recally correctly) only represented 2 or 3 % of the S&P. By 2007 that had grown to 21%.
We have to return to that 2 or 3 %. That means that 90% of the banks, insurance companies and financial services companies simply must dissappear if this country is to return to financial health.
If the value of the finacial sector of the S&P has dropped from $3 trillion to $1.7 trillion, I’d say we still have about $1.4 trillion in losses left to go before we get to where we need to be.
October 10th, 2008 at 8:18 am
I’ve been reading your blog for a couple of years and I have to say this is, IMHO, your best post–clear, concise, and right on target. My hope is that we will keep trying enough different approaches that we will stumble across ones that will enable the world economy to begin working again before we become a Socialist economy.
October 10th, 2008 at 8:18 am
BR for Treasury Secretary with the Obama Administration !!!
October 10th, 2008 at 8:19 am
Barry, come on now, that’s ENOUGH : authorities are simply late on purpose and programmed this descent.
Criminality should not be misinterpreted as incompetence.
October 10th, 2008 at 8:22 am
to fix the excessive debt problem is easy,
just let the debt liquidate by market forces, do not interfere.
We need the debt bubble to continue to implode , not try to fix it.
October 10th, 2008 at 8:24 am
Fire Bernanke. Fire Paulson. Bring in a couple of well respected people in the industry like Paul Volcker.
October 10th, 2008 at 8:25 am
A common expression from times past was “We must address the root of the problem and not the symptoms”. We need to ask ourselves what this is and how do we fix it.
The problem is that homeowners are unable to pay their mortgages. This is resulting in foreclosures, 10,000 a day and growing. This in turn is resulting in reductions, and worse – uncertainty – in valuing mortgage backed securities and associated derivatives, which in turn is eviscerating bank capital.
We will not solve the crisis until we solve the foreclosure problem. PURE, PLAIN AND SIMPLE.
October 10th, 2008 at 8:26 am
In a nutshell: there are limits to capital. Not even government can exceed them. Money represents, mostly, accumulated promises of future work. Cleary, that must relate to the number of people (and the efficiency of their work). Create too much money and it can never be redeemed – by definition. That is why debt collapses when it gets too great.
At that point there is no government or policy solution that can stop the collapse.
The only question remaining is: are we at that point today or somewhere else that just looks like it?
October 10th, 2008 at 8:28 am
Let me get this straight Barry, easy credit and low interest rates got us into this MASSIVE BUBBLE economy and your solution is more easy credit and lower interest rates ?
Why can’t we just allow free markets to work ? If a risky company needs short term funds they should pay much higher rates than T-Bills. This is how free markets allocate capital.
~~~
BR: How on earth did you get that from the above? Did you even read this?
October 10th, 2008 at 8:28 am
@ Wally totally agree. Pls check this out :
http://lacrisepourlesnuls.blogspot.com/2008/10/michel-drac-quand-limprvisible-est.html
October 10th, 2008 at 8:31 am
Barry writes:
“Identify the banks that cannot survive, and like Old Yeller, gently put them down.”
This is a big part of your argument. So…
1. Who would do the identifying? Treasury, Fed, Buffett??
2. How would the “survival threshhold” be established? Again, by whom?
If identifying banks that were not going to survive was that simple, the credit markets wouldn’t nearly this frozen. I don’t get this post at all.
~~~
BR: As I wrote above: “The Treasury should announce a matching program, where any private investment into a Bank is matched by the government, dollar for dollar, and on the same terms. This fixes not merely a balance sheet issue (like TARP does) but the actual capital structure at the root of the current crisis. And it does so on terms that are good for the taxpayers too. “
October 10th, 2008 at 8:32 am
We do NOT need to inject capital into these failing banks. They need to fail, and new banks need to emerge. And they need to liquidate there “assets” to people who still have money. If they don’t like the price, tough. Why should we support horrible firms who made horrible decisions?
October 10th, 2008 at 8:38 am
our host – “Assuming they were careful about who they made loans to, this was a profitable enterprise”
in the voice of Will Smith
“I gotta get me some of that”
says Wal-Mart
October 10th, 2008 at 8:42 am
BR,
This was a good post, thanks.
I only take issue with one comment, the one about Old Yeller! If I remember that movie correctly he wasn’t gently put down, the dog got hydraphobia and was shot dead after being locked in a shed!
I might liken this to the approach used with Lehman and that hasn’t worked real well as we all know.
Another interesting thing is looking at the description of how banks operate. Faber wrote recently is his monthly about the idea of the top 20 banks cutting dividends, which at time of writing were about 40 billion a year. this would have freed up 400 billion in lending capability ($1 in capital = $10 of lending), would have been more than half the TARP and no taxpayer money. Decent idea but how safe are any of those dividends anyway, (BAC, C, etc.)
today is going to be crazy and it will all get started with a speeach from GW and what the hell is the point of that.
October 10th, 2008 at 8:45 am
and CME Jack – ya the markets are trading down because the Dems new sheriff is coming to the wild wild west new world (if machines work right)
ain’t that a good thing really? if ya position for it
October 10th, 2008 at 8:46 am
We can pump hundreds of billions in new equity capital into the banks (and now we must), but then ask ourselves; “Will this get banks to lend again?”
The answer will be “NO”. Why? Because we have not addressed the continuing uncertainty over the value of mortgage backed securities and derivatives.
Banks will not lend again until this is fixed. Buying $700 billion in bad paper is fine, but what about the trillions of bad paper still out there with uncertain valuations?
We must assist distressed homeowners and their ability to pay their existing mortgages and we must find a way to take out (refinance) these bad mortgages with new loans that will have much lower default risk.
We must keep the homeowner’s ability to pay at least some part of their mortgage costs into the cash flows that feed the financial system.
This is not about capitalism, socialism, fiscal responsibility, moral hazard, punishing the responsible……It is about survival.
October 10th, 2008 at 8:50 am
A financial institution in need of a capital infusion is having a solvency problem, not a liquidity crisis.
October 10th, 2008 at 8:53 am
I agree with Andy’s comment: “No more unregulated CDS’s.”
I think that is why the banks don’t trust each other. They don’t know what the CDS liabilities are; the bookkeeping is totally in disarray. Until that’s solved, I believe this crisis will continue.
From a headline story at Bloomberg right now regarding CDS’s:
“No one knows exactly how much is at stake because there’s no central exchange or system for reporting trades. It’s that lack of transparency that has increased the reluctance of financial institutions to do business with each other, exacerbating the global credit crisis and prompting calls for regulation of the market.”
http://www.bloomberg.com/apps/news?pid=20601087&sid=aa6nmsv7BakE&refer=home
October 10th, 2008 at 8:53 am
BR: I think everyone has now got around to realizing the Brit/Swedish/Buffett solution is the best way forward. Why has it taken 9 months to get there. Politics. You saw how hard it was to pass the bailout bill a couple of weeks ago. Imagine if Paulson had been able to break out of his free market/deregulatory paradigm nine months ago and had gone to congress and said give me a trillion bucks to essentially partially nationalize the banks and start buying up their paper. Firstly Cheney in his undisclosed location would never have signed off on it while Dubya would have been talking about suckers. The Republicans would have been demanding men in white coats come and take Paulson away. It simply wasn’t politically feasible. Now the entire free market deregulatory system beloved of the right is collapsing it’s please govt come and save me. Meanwhile our economic and financial paper of record, the WJS who are prime proponents of deregulation and free markets, is leading with an ed about why Chris Dodd should be investigated because he may or may not have got preferential treatment on his mortgage. Beam me up Scottie.
October 10th, 2008 at 8:59 am
Barry,
A bit of a contradiction in your post. First you say that the banks were poorly run and then you say that inaction by the government (acting too late is how you put it) has caused the sectors value to drop.
Could it be that being poorly run is what caused the sector to drop? Can you give us some examples of “good” banks that have/will go bankrupt unnecessarily.
October 10th, 2008 at 8:59 am
Quite similar to what Floyd Norris has written in NYT.
All along has been a solvency problem and not a liquidity problem as Fed would have one believe.
But once you have capital, what would happen if further losses in the assets held by banks eat up all of that? After all, one never knows when the housing market’s freefall is gonna end.
October 10th, 2008 at 9:00 am
The problem appears not attributable to inadequate capital but to banks creating inordinate supply of credit out of thin air!Abolish fractional banking,the banks and intermediation. Allow people to meet in a proper market place to borrow and lend to each other based on a private contract.
October 10th, 2008 at 9:01 am
One more comment about the magnitude of the CDS nightmare:
“Tomorrow will be a massive test for the credit default swaps market as dealers and investors get together to determine the settlement value of credit default swaps (CDSs) on failed broker Lehman Brothers. With approximately $400 billion in notional amount of swaps outstanding, if the swaps settle at 12.5 cents on the dollar (which is where Lehman’s reference bonds are trading), swap sellers could face losses totaling $350 billion.
That was no error: The figure is $350 billion — half the amount of the Paulson bailout plan. For comparison, it’s almost ten times the CDS losses due to the nationalization of mortgage giants Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE).”
http://www.fool.com/investing/dividends-income/2008/10/09/the-next-350-billion-hole.aspx
October 10th, 2008 at 9:08 am
Have to disagree with you Barry, the reason banks are lending is because deflationary spiral has reared it’s ugly head. Why lend today when you can scoop up assets at half price tomorrow. Wait a day, save 10%. If you have cash, why not wait for the terms to get sweeter? Dollar matching, sure, I’ll take that. 10% interest? No problem. Your daughter’s virginity? If it’s on the menu.
The only way to break this cycle is to start taking over banks, get them lending to each other, and build a new banking system around those inter lending banks, and then keep going.
“Too sick to lend, is too sick to live.”
October 10th, 2008 at 9:10 am
BR,
I agree completely with your post, except for the part where we have to trust congress. You see, we’re at the point now where NOBODY trusts what congress does. Nobody is going to want congress to have the power to decide who wins and who fails. In a society where we trust our leadership, this plan would be spot on, but in today’s environment, government is going to have a hard time pushing this through without a full-on taxpayer revolt.
October 10th, 2008 at 9:14 am
Oh god, everybody has a plan.
Here’s a plan that will work–do nothing. Let the market sort it out and it will sort it out. I said along with a lot of other folks that all plans are doomed to failure. When the markets are bottoming on their own the “last” plan tried will be claimed the winner as the crowds cheer much as the rooster does, thinking he caused the sun to rise. Market crashes don’t cause depressions the plans do.
Let the markets freeze up. Let them shut down. Let the world economy grind to a halt. If left alone it will be temporary. Most of you folks have not a clue as to how the markets work. You are always screaming for something to be done when markets crash and deflation looms. That’s how markets work. They purge excess. Depending on the excesses sometimes the cure is very painful.
Here right in front of your eyes it will be working today.
“More than 350 banks and investors signed up to settle credit-default swaps tied to Lehman. No one knows exactly how much is at stake because there’s no central exchange or system for reporting trades. It’s that lack of transparency that has increased the reluctance of financial institutions to do business with each other, exacerbating the global credit crisis and prompting calls for regulation of the market.”
That’s how it gets done.
And I repeat, today’s rhetoric has been heard countless times in financial history.
It ain’t different this time.
October 10th, 2008 at 9:20 am
Great post! I’ve been looking all over the internets for a clear explanation of what is going on. I’m curious: what do you think of Krugman’s comments?
October 10th, 2008 at 9:23 am
Hello Barry
Thanks for the forum.
Fix the credit problem???
Credit is the problem!
“I promise to pay the bearer upon demand the sum of…”
Yeah, so long as I make x% on it.
As we speak 25% of the world’s mammals face extinction. Personally I find them warm and furry and fabulously fingered.
Sod the world”s bankers!!!
All you may desire is money, but all you need is love. We are all about to REALIZE that soon.
There is no “rational greed”.
economics is not a science, it’s an arrogant interpretation of the history of credit. Sadly, history is chaos.
economics is a sub-set of the ecology, not the other way around. The current “economic’ situation reflects this basic fact.
Fear of suvival is the problem for humans. Fear of the availability of ‘credit’ is a symptom of the underlying fear of ecological collapse, and a literal “rise of the lizards’.
I would suggest embracing a global rejection of credit, but I’m not so stupid as to think anybody is likely to listen to me.
The financial problem, as I understand it, is that nobody trusts anybody else to fulfill their commitments. Those commitments are based on a continuing policy of the rape (exploitation) of the natural world (ALONG WITH THE COLLATERAL DAMAGE TO MAMMALIAN SPECIES)
I certainly wouldn’t trust those lizards.
Best of luck to you, Barry, and all your worried friends. (That includes me).
At the end of the day we are all (hopefully humble) mammals on a very small planet.
Best of luck to all of us!!!
October 10th, 2008 at 9:31 am
Barry,
The little guy is taking his IRA out of stocks today because of a lack of confindence not a lack of capital.
The little guy is scared. I see them in my business all day long every day.
And besides, how many times in a lifetime do you expect to have to go through a market crash…most adults remember the tech bubble, and I would not be surprised to see money go back into equities VERY slowly this time around….
Fool me once, shame on you…
Fool me twice, shame on me..
October 10th, 2008 at 9:32 am
“letting weak banks fail, strong survive” won´t work, because all the players are interconnected.
it was lehmans failure that accelerated the implosion of the interbank market.
let´s say we let MS fail – i don´t see how “strong” banks (if there are any) will get by.
like others said: it´s time for a move on CDS.
transparent trading may be a good thing, but it doesn´t get the problem: the lack of capital in case of defaults.
this market is still 55t.
i honestly don´t know if this would work: but how about killing all CDS contracts immediately?
ok, this would leave alot of positions suddenly unhedged and could cause further stress.
but on the other hand we´re at a point where things can´t get worse.
and: whats a CDS anyway worth if the counterparty that wrote it will go bankrupt due to frozen markets?
October 10th, 2008 at 9:36 am
There have always been crashes and there will always be crashes. Books have been written about them and this one will just be another chapter. In every one, people have been hurt and others have done well if they got out near the top. Regulation helps delay them and diminish their effects, but will never stop them. Greed and stupidity always trumps competence from time to time. Also, since this is a zero sum game, we are only hearing from those on the wrong side.
True, some losers are innocents but these same innocents benefited when up was the only direction anyone saw. The nimble ones got out at a prudent time. The ignorant ones just sat still. The dumb ones thought they were smarter than the market and are scrambling now.
Ditto with those who are enamored by the smooth talk of financially oriented sales folk who think experts who can outsmart everyone else really exist. This latter group will only exchange one group of experts for a different group who claim to really know what’s going on. (Maybe they backtest??? Ha Ha) People who make their living as experts won’t be going out of business soon. They’ll just be swapping customers with each other.
Now it’s time for government to do it’s rightful duty and pick up the pieces from excess brought on by a free market.
For what it’s worth, I think we’re about 10%, more or less, from the bottom, unless some new shock comes out of the blue. Historically, this one isn’t appreciably unique. At least yet.
October 10th, 2008 at 9:37 am
aaaaaaaaaand we’re under 8000
October 10th, 2008 at 9:48 am
“i honestly don´t know if this would work: but how about killing all CDS contracts immediately?”
They are an insurance contract; insurance contracts can (and frequently are!) RESCINDED. Rescind CDS’s. Unwind them, all of them. Or is the problem that Wall Street doesn’t want to give back the obscene profits it made selling the damn things?
October 10th, 2008 at 9:48 am
hmmmmmmm……I’m thinking we ought to see if there are anymore factories to send overseas.
October 10th, 2008 at 9:51 am
Lack of return on capital is to me the root of the problem. This sounds so basic as to perhaps make me look stupid.
Interest rates need to go up. That is interest on savings accounts, GIC’s, etc. Money would then be available – maybe not right away, but in several months there would be private capital available to banks. It would of course hurt like hell if you had to actually pay to borrow money.
For those with long memories one core problem in the Seventies is that you could borrow for less then inflation – so those that borrowed big did well – until they really winched up the interest rates. Then the pain and finally a new platform from which to grow. Do you know the name Paul Volcker – the real patron saint of the last 25 years of growth (not Bubbles Greenspan)?
There are going to be plenty of mega-losers and if Paulson wants to fend these losses off it will only get much uglier later.
There I’ve said my piece.
October 10th, 2008 at 9:57 am
Moon of Alabama suggests declaring all CDSs null and void. Thoughts?
October 10th, 2008 at 9:59 am
Bruce in Tennessee | Oct 10, 2008 9:31:21 AM
The little guy getting out of his IRA today is screwed. If he didn’t at least six months ago move at least enough of his investments into cash to withstand a two or three year siege without selling anything at a discount he’s done.
By the end of this weekend were going to have FDR II. Total guarantee of deposits, total guarantee of interbank lending, massive economic stimulus, partial nationalisation of banks.
October 10th, 2008 at 10:04 am
Posted by: Dan | Oct 10, 2008 9:48:46 AM
You can’t unwind CDS without triggering a whole new round of exposure. Why the hell do you think they are propping up AIG. That’s what they are struggling with in trying to unwind the Lehman swaps, it’s why Paulson made a big error in letting Lehman go which was done for reasons of politics and perception basically. Not an option I’m afraid.
October 10th, 2008 at 10:32 am
RE-BOOT
Cancel All Debts.
There is so little time.
The $4 riders are saddling up.
There is so little time.
October 10th, 2008 at 10:32 am
The primary problem is that banks are refusing to extend credit to each other. Why? Because they do not understand the liabilities of their counterparties. Translated into English, *** that means they don’t know if the other bank whom they are dealing with will still to be standing tomorrow. ***
The thing roiling markets today is not the lack of confidence;
————-
This is very much a lack of confidence – in the other guy.
October 10th, 2008 at 10:37 am
Bush: Nothing new.
Probably will end down from where he began.
Should have taken questions.
October 10th, 2008 at 10:41 am
John2
I agree. I spoke with a wealthy, although somewhat economically simple minded man this morning, who is content just to stay where he is…and of course this is down from 14000….for the life of me, I don’t understand complacency in investing…I am not saying you jump up and down like the world is ending, but you do make changes based on the way the world changes…
I just don’t follow it.
October 10th, 2008 at 10:46 am
I’m not an expert but…
more humbly:
The question seems to be cause — what’s the cause. Many people are saying ‘the banks are afraid to lend because they don’t know what’s on the other guys balance sheet’. As a non-expert, I’ll just assume that under that scenario the solution is as you outlined.
On the other hand there seem to be a couple of other scenarios. The big one is ‘banks are afraid to lend because they don’t know how much THEY owe due to CDS exposure’. The insurance industry too is a nice 19th century business model, which like banks, was a real scam, and routinely ended up in belly up insurance companies as a result of mispricing risk until government began to regulate the insurance business. It seem like the CDS market has been an insanely under-regulated insurance business, with everyone in town trying to be in the insurance business. Further, everyone in town has been drinking the kool-aid with regard to the wonders of self-regulation, and the great and glorious ever ascending market — more practically people have been assuming low risk on the CDS’s they write. Just like making home loans without regard to risk, everything works great while the tide is rising, but, the tide is now going out.
Seems like the issue of ‘transparency’, or ‘good bank/bad bank’ maybe quite a bit more complicated if any given firm itself has no idea of what it’s CDS exposure is going to cost.
Under the category of I’m not an expert, but:
Seems like simply nullifying CDS contracts would then leave a whole lot of people with balance sheets that need to change from having a nice asset, to having a big loss where that expected CDS payout used to be. That sounds bad when the CDS payout numbers are on the order of 600 trillion.
Insurance companies that don’t pay out to homeowners because they incorrectly priced the risk of a hurricane is one thing. Insurance than doesn’t pay out to financial firms that control the economy is another.
October 10th, 2008 at 11:02 am
I think this is inline with Barry’s point, the TED Spread is a quantitative metric that puts this bank mistrust into a perspective.
“The TED spread is an indicator of perceived credit risk in the general economy[1]. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. When the TED spread increases, that is a sign that lenders believe the risk of default on inter-bank loans (also known as counterparty risk) is increasing. Inter-bank lenders therefore demand a higher rate of interest, or accept lower returns on safe investments such as T-bills. When the risk of bank defaults is considered to be decreasing, the TED spread decreases[2].”
http://en.wikipedia.org/wiki/TED_spread
Currently, the TED Spread is off the charts:
http://www.bloomberg.com/apps/cbuilder?ticker1=.TEDSP%3AIND
October 10th, 2008 at 11:09 am
for the life of me, I don’t understand complacency in investing
———————–
A great many people sock money away in their company’s 401k on an automatic basis, and rarely take a close look until a crisis develops. By then a great deal of the losses have already occurred. This is part of the great stock ownership mantra people have been sold over the years, not unlike owning a house . . . I’m sure a great many are asking if this is such good advice if the market tanks because of the poor oversight and judgment and greed within the halls of government and the financial industry that seems to stack the deck against them.
October 10th, 2008 at 11:43 am
The banks don’t lend to each other, not because they fear insolvency (which would require capital), but because they fear other banks will not lend to them, and thus put them out of business. Please consider the following:
http://www.ft.com/cms/s/0/3c29a40a-9617-11dd-9dce-000077b07658.html?nclick_check=1
October 10th, 2008 at 11:45 am
The banks don’t lend to each other, not because they fear insolvency (which would require capital), but because they fear other banks will not lend to them, and thus put them out of business. Please consider the following:
http://www.ft.com/cms/s/0/3c29a40a-9617-11dd-9dce-000077b07658.html?nclick_check=1
October 10th, 2008 at 11:47 am
Welcome … to society 2.0!
It is a society marked by no leverage, banks that can only give a loan from their deposits 1 – 1. Banks who are not allowed to do any speculations what so ever in any instruments, this is left to the investment “entities”. Banks that can have no entities off their balance sheets – no SUV’s etc. A society that recognizes that the housing markets are highly liquid when the prices are rising, but highly illiquid when prices drop.
… And they all thought the world was much more better!
October 10th, 2008 at 11:49 am
For those that say “let the free market sort it out” you are not seeing the big picture. The markets can’t sort it out because of the CDS monster. The whole system would implode in a matter of days. The credit market as at the brink NOW, waiting on LEH to settle today. Imagine if JPM and GS were allowed to fail (and they would) without intervention ? Just those alone would send a tidal wave that would crush the global financial system.
On another note, when Barry mentioned “identify” weak banks..the market would identify those banks. But First complete balance sheet transparancy would be required. The market would use this information to determine the strong from the weak. Many banks would be nationalized and liquidated, others would be injected with capital and survive. Most importantly trust would be returned to the system.
October 10th, 2008 at 11:55 am
Insightful. What must be done? Legislate the banks to ‘fess up? The free market is guessing the capitalization of the banks and deleveraging. The result is a stock market collapse.
October 10th, 2008 at 11:58 am
Barry,
This was an excellent post. Thank you for the clarity as always.
When “this” ends, we will need a completely new class of people to “run things” because everyone who has been in charge is totally tarnished by their complete incompetence. I am sure that we will find there has been gross malinvestment by many of the states, cities and many large institutions as well. It will take years to weed out the perpetrators.
I would be quite comfortable with Volcker, Ritholtz and Roubini as the new Treasury team.
October 10th, 2008 at 12:05 pm
Michael Kao writes on Yahoo! Finance:
Each “solution” has been hamstrung by an embedded “anti-solution”: “Bailing out” Fannie Mae and Freddie Mac shut down the entire market for preferred shares once Paulson decided to suspend dividend payments; allowing Lehman to fail without a plan to deal with the counterparty obligations caused an immediate run on AIG ; seizing 80% of AIG’s equity in return for providing a bridge loan directly caused runs on Goldman Sachs and Morgan Stanley ; the disallowance of short-selling of equities forced market participants to pressure the debt market of the underlying companies, causing “death spirals” due to consequent ratings agency downgrades and forced selling by long equity holders; the arbitrary seizure of Washington Mutual and the government-assisted pillaging of its capital structure by JPMorgan did not assuage investor confidence — it severely damaged it and directly caused the run on Wachovia ; the arbitrary treatment of Wachovia in the FDIC-assisted sale to Citigroup and now the federal meddling in the Wells Fargo /Citigroup spat again shows that there are no set rules or templates that investors can follow.
Little wonder that people who are otherwise paid to take risk refuse to do so in this environment.
(taken from “Our Timid Government Is Killing Us”)
The Truth Shall Set You Free – Extreme Volatility
October 10th, 2008 at 12:17 pm
The $850 billion was a mistake and won’t solve the problem? No one in the govt can articulate what the problem is.
It is obvious that the world was in a credit fed bubble. Oil went from $40 to $150 and people were telling themselves it was due to China and India. Could of been, but I think events are proving it was simply an asset bubble. Houses went up In America and Europe.
The bubble has to collapse. Now suddenly the governments of the world think they can stop it. How did they unlearn so much? They need to read a book about popular delusions and the madness of croweds.
October 10th, 2008 at 12:18 pm
BR writes:
Does this mean BR doesn’t think there was a financial sector bubble? The sector may be undervalued now, but it was clearly overvalued then. Mourning over equity loses in banks is like mourning over falling housing values: it’s a needed correction. Get over it. It’s not costly to give back undeserved bubble gains; it’s unavoidable.
Also, I still think the cheapest and least morally hazardous route out of this is to help fund new banks, which everyone can have confidence in and can be placed under tighter regulations to ensure safety for the time being. Let the bad banks fail and guarantee all deposits in the meantime to avoid a premature run. Trying to sort out “good” and “bad” banks now will require lots of time and subjectivity. Just introduce some new banks with no CDS exposure, MBSs, etc. The existing healthy ones will survive, and the bad ones will fail. It would be volatile in the short run, but it’s the easiest way to purge the system and resume confident lending.
October 10th, 2008 at 12:19 pm
Barry – is fear of Government Confiscation because of their inconsistency part of the bank capital problem ?
WaMU: FDIC threw WaMu’s equity and bond capital under the bus
Wachovia: FDIC saved Wachovia’s bondholders, then equity holders got a break from Wells Fargo’s offer, but all done so sloppily that WB capital is uncertain about legal liabilities from Citibank…
Lehman allowed to fail with massive CDS contagion, AIG saved -
No consistent theme – if I actually had a few billion I’d be very leery (unless I had good inside friends at GS/Treasury to give reassurance!).
October 10th, 2008 at 12:23 pm
Naked Capitalist is reporting reliable source of inceidents of banks refusing Letters of Credit which is impacting shipping transactions between buyers and sellers. I.E., goods are stacking up in international ports.
Thats pretty bad mojo if it dominos between more banks. The example given was between BNP Paribas and Citi, no small town hick banks, those.
October 10th, 2008 at 12:27 pm
Barry,
i think it isn’t ‘the other counterparty’ risk, but an institution’s own CDS exposure that has them frozen. none of this is ‘booked’ yet, as a loss, it’s trillions in exposure. the institution computes, ‘i hope this guy is better off than we are…’
Leverage is beautiful on the way up and ugly downside.
transparency and reverse forensics is immediately needed. to survey the ‘actual’ counterparty risk, and determine the real exposure. somebody better step in or…
the market will figure all this out, with fantastic damage will ensue given the role ‘fear’ plays in investor’s decision making.
an CDS exchange/clearing house is needed immediately.
lastly, CEO’s and corporate officers found of extreme negligence should be declared ‘financial terrorists’ ‘enemy combatants’ and shipped off to Guantanamo.
if the allegedly most transparent, fair and well managed exchanges in the world are this corrupt, no wonder markets are roiling….
-bnr
October 10th, 2008 at 2:52 pm
Great post.
I agree with others that housing and home loans are another symptom and not the root cause of the current lending freeze.
CDS and other derivatives are the problem and estimated in the hundreds of trillions of $$.
Could it be that the government is avoiding transparency in the CDS market because they know that there just arent enough assets in the entire system to cover the bad paper?
A sudden disclosure would cause a collapse of banking so they need a Japanese-style many-year slow unwind with gradual losses. And they cannot say this because that would the same thing as sudden disclosure.
What a @#$ mess.
October 10th, 2008 at 7:08 pm
@Rich Shinnick rant about the role of the government.
Talk about circular logic: the gubmint is bad, because, well…the gubmint is bad.
Apart from this gaping flaw in logic let me ask you this: You know of any other player that has the legal and financial firepower to shore up the credit market system ON SHORT NOTICE? As in < 3 weeks, (if that) ’cause we are heading for the mother of all meltdowns if this doesn’t get resolved FAST.
October 10th, 2008 at 11:01 pm
I don’t know why people keep referring to this as “Nationalisation”? I believe this is just political rhetoric because it could just as well be described as an investment. Just like Buffett, the taxpayer gets a 10% return on Preferred stock and sells it at a profit down the road. That’s a good investment which simultaneously fixes the banking system.
Incidentally, PLEASE let’s not forget to fix the regulatory problems and the inherent conflicts of interest in the Rating Agencies. Let’s also get ALL derivatives traded on an exchange No more OTC B/S and no more SIV’s, Conduits and the like.
Then we can make a fresh start and wait for the next round of financial creativity, which WILL happen. One of the lessons our Wall St friends have learned is that you take your money before the sh*t hits the fan, you will be OK and the Government will pick up the tab so no problem. That depressing reality almost guarantees it will all happen over again if we allow them more than half a chance.
October 11th, 2008 at 3:19 am
A very interesting and predictive post. I read an article in the Fin Review last week that predicted 2.8 million mortgage defaults in the USA in the next 12 months. That is very, very scary indeed.
It wouldn’t surprise me if Russia, Iran, or North Korea take advantage of this crisis and the upcoming US election to launch some sort of attack or grab for territory.
October 11th, 2008 at 12:41 pm
“The primary problem is that banks are refusing to extend credit to each other. Why? Because they do not understand the liabilities of their counterparties.”
Are we sure this is the reason for such little inter-bank spending? Lots of people and institutions are cashing-out accounts. Perhaps the banks CAN’T lend because their cash reserves are below permissible levels. The implications of this scenario are very different and more concerning than a simple matter of suspicion among banks.
Are there any near real-time data on cash reserve holdings of banks?
October 11th, 2008 at 12:44 pm
Re: the fractional reserve banking mention:
Wouldn’t it have been much simpler to just say that fractional reserve banking actually doesn’t work, if indeed it ever truly did for anything but the most basic, localized use? Seriously, if the government itself has to recapitalize banks I don’t see how that can be classified as other than systemic Fail.
October 12th, 2008 at 4:33 am
Barry, you say “The thing roiling markets today is not the lack of confidence; It is capital, or more accurately, the lack thereof”. How is this not in large part because of the continuing fall in asset prices? As house prices drop banks are forced to lower the book value of their CDOs, which lowers their reserve ratio, which forces them to raise more cash and lend out less.
Moral hazard and affordability considerations must be put aside immediately and house prices stabilized.
How about this simple approach which can be implemented in one day and costs nothing at the outset:
Have the US government guarantee all primary home purchases in the next six months against loss of value as long as the owner stays in it for four years. If after 4 years the home is sold for 10-20% less than purchase price the government will cover 50% of the loss. 75% if over 20%.
Besides the aforementioned benefits, this approach would:
- Inject confidence in the market so people on the sidelines waiting for a bottom are much more likely to jump in, thereby slowing the downward spiral in prices.
- No application, approval or signup process, so it can be implemented by passing a bill and having a press conference.
- If market prices do stabilize no claims will be made and the program cost will be zero.
- If they don’t, banks include the government guarantee in their books when valuing the notes. Also, costs will be deferred and incurred over time (most participants won’t sell right at 4 year anniversary).
- Simple limits such as 1 million max property value, and one property guarantee per family (no corporations or trusts) will minimize speculation and abuse.
- Everyone is eligible automatically, so no preferential treatment, or gaming the system.
October 12th, 2008 at 1:45 pm
what do we do besides pray and pay? I am a retired senior and angry. I am also a member of Myinvestorsplace.com., where answers and solutions are sought. Any ideas??
October 13th, 2008 at 5:34 am
The must-read pieces in the Wall Street Journal (online dated Oct. 11)
“Rescue Plan Comes Around to Views of the Academics”. I think it’s early to declare victory–especially since we’ve yet to find out that if the government does what academic economists advise that it will help–but it does look like the…
October 13th, 2008 at 5:34 am
The must-read pieces in the Wall Street Journal (online dated Oct. 11)
“Rescue Plan Comes Around to Views of the Academics”. I think it’s early to declare victory–especially since we’ve yet to find out that if the government does what academic economists advise that it will help–but it does look like the…
October 13th, 2008 at 5:34 am
The must-read pieces in the Wall Street Journal (online dated Oct. 11)
“Rescue Plan Comes Around to Views of the Academics”. I think it’s early to declare victory–especially since we’ve yet to find out that if the government does what academic economists advise that it will help–but it does look like the…
October 14th, 2008 at 12:57 am
Bailout 2.0
Bailout 2.0 From the WSJ: “The U.S. government is expected to take stakes in nine of the nation’s top financial institutions as part of a new plan to restore confidence to the battered U.S. banking system, a far-reaching effort that…