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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.

Friday, October 10, 2008 | 07:30 AM | Permalink | Comments (73) | TrackBack (2)
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Comments

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?

Posted by: Mark Peecher | Oct 10, 2008 7:44:00 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.

Posted by: Elvis | Oct 10, 2008 7:45:32 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.

Posted by: jbd | Oct 10, 2008 7:48:14 AM

The SUN is shining. Have a good day!

Posted by: MM | Oct 10, 2008 7:48:53 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'

Posted by: Mark E Hoffer | Oct 10, 2008 7:53:29 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?

Posted by: Rich Shinnick | Oct 10, 2008 8:00:10 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.

Posted by: Andy | Oct 10, 2008 8:03:00 AM

Forgot to address one small thing:

The housing bubble

Posted by: Freddie Big Mac | Oct 10, 2008 8:07:21 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.

Posted by: SL | Oct 10, 2008 8:08:52 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.

Posted by: Kevin | Oct 10, 2008 8:13:01 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.

Posted by: DownSouth | Oct 10, 2008 8:16:09 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.

Posted by: dallas | Oct 10, 2008 8:18:00 AM

BR for Treasury Secretary with the Obama Administration !!!

Posted by: Todd | Oct 10, 2008 8:18:30 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.

Posted by: michange | Oct 10, 2008 8:19:08 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.

Posted by: rickrude | Oct 10, 2008 8:22:45 AM

Fire Bernanke. Fire Paulson. Bring in a couple of well respected people in the industry like Paul Volcker.

Posted by: Mike M | Oct 10, 2008 8:24:48 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?

Posted by: wally | Oct 10, 2008 8:26:14 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?

Posted by: Freddie Big Mac | Oct 10, 2008 8:28:23 AM

@ Wally totally agree. Pls check this out :
http://lacrisepourlesnuls.blogspot.com/2008/10/michel-drac-quand-limprvisible-est.html

Posted by: michange | Oct 10, 2008 8:28:38 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. "

Posted by: Dan Duncan | Oct 10, 2008 8:31:01 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?

Posted by: s0mebody | Oct 10, 2008 8:32:33 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

Posted by: Greg0658 | Oct 10, 2008 8:38:27 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.

Posted by: ben | Oct 10, 2008 8:42:22 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

Posted by: Greg0658 | Oct 10, 2008 8:45:08 AM

A financial institution in need of a capital infusion is having a solvency problem, not a liquidity crisis.

Posted by: Winston Munn | Oct 10, 2008 8:50:09 AM

December 2008

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