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Friday, February 13, 2009

The Economic Response:The Fallacy of it All

Whether it's TARP, the auto bailout, the plan to help distressed homeowners, and much of the stimulus, the government's response to the economic crisis has been to help all those that failed, took excessive risks, or acted irresponsible and/or incompetently. On the one hand, this is natural. Those that didn't do any of these things need no help. On the other hand, rewarding failure is a recipe for disaster.

So, what is TARP? It's a program to prop up banks that took on risks that have now blown up on them. Far be it for me to normally agree with Arianna Huffington, but on this point I have to agree.

What needs to be done is hard but straightforward. As Martin Wolf of the Financial Times sums it up: "Admit reality, restructure banks and, above all, slay zombie institutions at once."This tough love for bankers is being promoted by everyone from Nouriel Roubini, Paul Krugman, and Ann Pettifor to Niall Ferguson, the Wall Street Journal, and Milton Friedman's old partner, Anna Schwartz, the co-author of his seminal work, A Monetary History of the United States, 1867-1960. "They should not be recapitalizing firms that should be shut down," says Schwartz. "Firms that made wrong decisions should fail."

The plan laid out -- or, more accurately, sketched out -- this week by Tim Geithner makes it very clear that he is on the wrong side of the issue, more worried about the banking industry than the American people. Like Hank Paulson before him, Geithner appears more concerned about saving particular banks than saving the banking system. No real shocker there. As Henry Blodget points out on HuffPost, it's hard to be surprised that Geithner is sticking with the Paulson plan "inasmuch as he was
likely the one who created it."

In fact, while Geithner's plan was sketchy at best, one thing he did lay out was a stress test. This so called "stress test" will determine if a bank qualifies for financial assistance. In other words, a bank's balance sheet needs be jacked up enough in order to qualify. If you are bank that was dutiful in lending and investment then you don't qualify. This is a recipe to reward failure and that's a recipe for disaster.

Then, there is Obama's plan to save struggling homeowners.

Several major banks are expanding their efforts to halt home foreclosures while the Obama administration develops its plan to help struggling homeowners.

The White House said President Barack Obama will outline his much-anticipated plan to spend at least $50 billion to prevent foreclosures on Wednesday in a speech in Arizona.

"It's not intended to be measured by one day's market scorekeeping, but instead to ensure that the 10,000 Americans each day that have their homes foreclosed on, and the millions more that are barely getting by, are protected," White House press secretary Robert Gibbs said Friday without providing other details.

In this plan struggling homeowners will get a subsidy and a brand new loan. Not only will their rates go down but sometimes so will the balances on the loans. So, what will you get if you are on time and you have a handle on your finances? Nothing, that's what.

Don't forget the auto bailout. The automakers, for years, ran poor businesses, and so what happened? They were rewarded with government assistance. What does a well run business like Wal Mart get? Nothing, that's what.

Look at the stimulus. It will increase funding to such programs as unemployment insurance, Medicaid, food stamps, etc. All of these are programs that reward failure. They prop up those that can't help themselves. While that may in fact be compassionate, it is also a recipe for disaster. Then, there is about $50 billion to help struggling states. How did these states become struggling? They overspent that's how. So, here is the federal government stepping in to bail them out.

All of this is a zero sum game. If failure is being rewarded it is at the expense of success. All of this bailout has to be paid out somehow. If you aren't a recipient, then you are one of the ones paying. As such, while the failure gets financial assistance, that same failure is being propped up by those that were and are successful.


Anonymous said...

The problem is a bit more complex than this analysis would suggest. Were the problem simply that the banks have bad investments, then I would agree with killing the weak is the path to moving forward. Over-The-counter derivatives complicate the picture, however. Each of these institutions have has a large derivatives book. These derivatives were purchased both for risk management and for speculative purposes. In either case, the effect was to bind the two institutions tegether. The end result has been to create a level of interdependence that has never been seen before. It is similar to the Japanese Kiritsu's that bound banks and industrial concerns together. In effect we have a single, global, bank that is in trouble. Each individual institutions is either marginally or wholely attached to this global bank.

So how do you save the banking system given these cross-holdings. Killing one istitution can kill others. Such was the case when Lehman went under. That almost killed all of them. What must be done is to break this interdependence. An exchange structure or a bad bank schenario can work. Both structures reduce the network mesh comlexity that currently exists with a hub-and-spoke structure that is simpiler to comprehend.

The problem is the transfer price and the gaming that occurs. If I have a set of assets that are underperforming, I might want to sell them. However, the market does not have enough liquidity to let me sell. The price that I will get will receive on the first sales, will force a remark of assets still on the book and probably bankrupt the institution. If I wait, the asset will perform at a level better than the sales price I obtain. So I could borrow money and hunker down and let time fix the problem. This doesn't necessarily work if another bank unloads and forces a remark of the portfolio.

This is a bit like Siamese twins threatening to kill each other. it's mutually assured destruction. This is where we are right now, at a temporary equilibrium.

If each institution were to agree to move all of these assets off to a mutually owned holding company or exchange, a new equilibruim could be brought about. Imagine that they can agree on a value of these securities in an impaired, but functioning market ( a really big if). Move all of the securities and derivatives into the holding company/exchange at this transfer price. That value is now equity value in the holding company. Derivative contracts moved into this structure from both parties and cancelled, but the counterparties get equity value (plus or minus) for them.

This entity can now trade with anyone. Selling off components of the portfolio. Profits/losses on the portfolio accrue to the exchange and are distributed to the equity holders. Equity holders can trade with the exchange. This will ensure that firesale prices are not required. The banks agree to get out of the practice of writing derivatives with each other in favor o utilizing the exchange (or other exchanges that might develop). This keeps the web of cross-holdings from redeveloping. It also increases the equity value of the exchange and thus helps the bank. If the exchange operates successfully, they each gain a price better than they could alone. It allows them to move back into competition with each other by means of cooperation.

This is better than the problem tht we have right now. While they are making new loans, they are forced to do this at the margin while time works them out of their portfolio problems. Time is not in their favor now as their lack of activity has a negative effect on the global economy. Unfortunately, waiting and borrowing funds seems to be their best option at the moment.

Anonymous said...

Thanks for the comment. You sound like you know what you are talking about.

I had a feeling the problem was far more complex than the shallow perspective given by journalists and bloggers under pressure to get people to read what they have to say.