Many economists are arguing that we should let the financial institutions that made poor investment decisions in exotic financial instruments fail and get on with life via a pure, free market clearing solution. The implication is that all will be better faster if we let the markets clear out the garbage quickly and assumes that the market is the best way to solve the problem. Let’s look at the situation to see if that is really true.
Their argument is that the banks/hedge funds/etc. are playing an elaborate game of chicken with an unsuspecting (or compliant, in the case of Bernanke and especially Paulson) government and the taxpayers. “Here’s my bad debt”, they say, “buy it and I can be strong again”.
I’d buy it if it were not for rapidly declining home prices. That’s the “asset” that backed many of these securities. No matter how stupid you think all the crazy derivative securities are (and they really are crazy), the underlying asset behind many of them is still headed south. The result is few people would touch most of this debt at par value even if the derivative crap were not an overlay.
Now the crafty hedge funds are already circulating to buy a big chunk of the “higher quality” debt before the government gets to it, or better yet will jump in after the bailout is announced and scoop up the tasty bits before the Feds announce how the program will work. So the market is definitely part of any solution, but perhaps not the entire answer. And note that they will have to hold this paper more than a few years until the housing market recovers.
In particular, what happens to the rest of the really toxic derivatives–MBS’s, CDO’s, CDS’s—after crafty buyers depart? The real crap could be bought by the taxpayers in the bailout at prices determined by, guess who, Wall Street’s best friend, Mr. Paulson. Once Hank buys it cheap (or not so—the prices will be public—we’ll see), we as taxpayers get to sit on a toxic waste dump of totally unsalable paper. Zero return is one likely outcome. Or it could fester on the owner’s balance sheets and slowly be marked to market by the end of the year, which means huge losses in banks, sovereign wealth funds, hedge funds, governments, pension funds, etc. all over the world. Trillions of dollars will be lost and liquidity further pushed out of the markets. You think we have had to pump a lot of cash into the markets so far, wait until the real write-down starts. My argument is that the taxpayers pay the piper either way—bailout or liquidity injections, both which increase the national debt. At least the bailout could make us a few bucks if the securities are not all dogs.
Who will end up suffering most? Perhaps the 20% of people who get chucked out of their homes as a result of this mess are the real victims….and they do live on Main Street, in spite of all the cries that the bailout saves only Wall Street. That bothers me somewhat as there are some good people in that mix that got sold (or sold) a phony story to the banks to get their loans. Home ownership is at historic highs, almost 70% in the US, perhaps too high, and now not a very good investment. Nothing in the bailout really addresses this issue and perhaps it should not. People will not walk away until the foreclosure, so it will be a slow and painful process lasting years. Does that mean the taxpayer should pick up the bill for asset deflation and let them stay in the homes? Not really, but we should think about how to deal with this part of the crisis as well.
Will people retreat to investing in the financial markets going forward, instead of owning homes? Probably not. The American Dream is still that picket fenced yard and home in the suburbs, although look for rapidly deteriorating prices the further you get from job centers due to high commuting costs. So inventories will remain high and even though household formation continues to rise, the new families may look to rent or live with relatives in the near term, further putting downward pressure on prices.
But we still have not answered the basic credit crisis question. Banks are fearful of lending, now that their collective stupidity has come home to roost, at least for the one that are failures. Since no one knows what exactly anyone else owns, it’s a game of Liar’s Poker. Interbank lending is slowing to a crawl with all this uncertainty. The hedge funds and bailout will provide a market for the junk in the portfolios. Once lenders see that the troubled banks have an out, they will consider lending again.
The short story is that The Solution has to have both a public and private component to be successful.
So Caterpillar pays 1 percent more for their short term loans? Should we really worry? It’s the cost of doing business in a crippled financial system. They are getting the money they need, albeit at a higher risk premium. Perhaps that lasts for a few months, and then credit loosens up and they refinance at 5%. Not much of an impact.
For the broader economy, a lot of pain is likely and that’s where the bailout has no impact as yet, unless they add some more goodies. Small business guys can’t borrow to save their souls and are using MC/Visa to meet payroll. I’d prefer to see the SBA start making more working capital loans for starters and then perhaps increase insurance to banks to cover possible small business loan defaults. Not a perfect solution, but one that would allow some breathing room for the financial sector to settle down. The increase to a $250,000 insurance limit on money market and checking/savings accounts is a joke.
Dealing with the complexity of this mess is far from over. Who’s to blame can be fought out in the post mortem books from the Wall Street Journal crowd. Hopefully, Congress gets this soon and acts.
A VC in Vacationland 