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Tuesday, March 3, 2009

The Only Thing That Will Save Us Now is the Free Market

Of course, this won't happen, but it should be on the record for posterity at least...

First, I want to introduce this quote from a Wall Street Journal article last fall.



Is a housing bailout the solution for clogged-up credit markets and a faltering economy? What the Fed has been doing and did again yesterday hasn't really worked, notwithstanding the pops it produces in the stock market every time it shovels liquidity into the system. The Fed's latest move provides financial institutions another $200 billion in direct short-term lending against their unsaleable housing collateral. The Dow Jones jumped 416 points. But it won't restart markets for the underlying collateral.

Where are the speculators, vultures and hedge funds? Where are the big money players willing to buy the exotic but still substantial mortgage-backed securities for which markets have ceased? The Fed's liquidity rush seems only to have convinced them the time is ripe for staying on the sidelines.

To get to a real solution, speculators and investors need to believe that home prices are hitting bottom, that any mortgage debt they might buy today for 80 cents on the dollar today won't be worth 30 cents tomorrow. Then the vultures will pile in: The transfer of wealth from the overleveraged banks and hedge funds to those who kept cash handy will be shocking, ugly and cathartic -- but it will also be relatively quick. Credit markets will begin to function again. The economy will grow.


I will refer to this piece throughout as I think it speaks to a fundamental point of economic cycles and especially downturns.

First, let me give a brief recap of how we got here. (for the full summary read the link) In late 1999, Alan Greenspan began raising the prime rate and this action lead directly to popping the internet bubble. That lead directly to the recession that awaited George Bush when he took office. 9/11 as well as the Enron et al scandals only perpetuated the recession and soon Greenspan was just as furiously lowering prime rate as he was raising it only a couple years earlier.

Eventually, he lowered the prime rate so much that the fed funds rate (usually three percent below prime) got to .75%. This created very loose money within the banking system. That's because it became far too easy for the banks to borrow. At the time, only real estate was thriving as an industry and so banks naturally moved all this loose money into real estate. Because there was more money then loans, eventually they created new loans and the sub prime explosion began.

Throughout the next four years, the real estate market became more and more speculative. Meanwhile, sub prime loans became more and more irresponsible. Finally, folks needed little more than a heartbeat to get a loan.

When the real estate boom finally subsided at the end of 2006, it also exposed loan portfolios that made up Mortgage Backed Securities that had an obscene amount of loans that weren't being paid back. Because these MBS' were making obscene amounts of money throughout the boom, these banks all got far too into these investments. Furthermore, much of this investment was done on margin. The crisis was exacerbated by the fact that FASB rule 157 forced these banks to apply current market prices to this paper. As the paper fell in price, the banks had to write them down on their balance sheets. Because much of this paper was used to meet minimum capital requirements, banks struggled to stay capitalized and lending dried up.

Finally, the whole crisis has become intertwined. The banks all owe each other so the failure of one could lead to the failure of most or of all. Furthermore, real estate values deteriorating puts further downward pressure on the MBS' they all are holding. As such, there has become a belief among many that many of these banks need to be propped up so that obligations are met and a domino effect is not created. Furthermore, there is a similar belief that we need to stabilize housing values to make sure that the value of these assets are stabilized as well.

I believe that both of these beliefs are foolhearty and implementing policy in order to create this is exactly the wrong thing to do. Of course, we'll never know what would have happened had TARP not been passed, but all those that were screaming about a crisis without it, should be asked what exactly is happening now. Without TARP, many of these institutions would have filed for Chapter 11 protection. Much of their debt would have been forgiven or restructured. As such, many of their debtors might have wound up in a similar position. Would this have meant that a lot of big institutions would have failed? Absolutely, it would. Would this have lead to more institutions failing. Absolutely, it would. Would it have meant that entire banking system would have collapsed? Absolutely, not. There would still be plenty of banks that would not only survive but in fact thrive. For instance, both Northern Trust, ABN AMRO, and HSBC have largely stayed out of sub prime. Those banks would make it through any crisis. They would likely be serious buyers in any garage sale of all these assets. (the vultures) Furthermore, most regional and local banks are far too conservative to ever get involved in sub prime. All of those banks would not only survive, but the innovative ones would grow. What we would see is a restructuring of the banking system with far fewer multi national powers and far more local and regional powers. We would also likely see non banking financial institutions like the Hartford enter the banking market because of the hole left by all of these collapsing powers.

Beyond this, many of these entities would then have been sold off for "spare parts". In other words, divisions like Smith Barney and AIG's homeowner's insurance would have been sold in the market. Not only would they have been sold, but the buyer would have gotten quite a deal. These buyers would have acted much like financial VULTURES. Of course, that's exactly what the WSJ article said was necessary for a bottom. Whoever would have bought Smith Barney would have received a deep discount on it. In fact, most of AIG, Citigroup, et al's divisions would be broken up and the buyer's would buy them at well below market value. All of the players left standing would wind up vultures and the bottoming process would occur and we would begin the recovery.


As for housing, it is equally foolhearty to think that housing needs to be stabilized. All of these folks that got these extreme sub prime loans should never have been in the real estate market to begin with. In order to stabilize the market, they need to be removed from it as soon as possible. Furthermore, isn't what we need now more buying? What creates more buying than low prices? Don't we want to encourage as many real estate vultures as possible? The only way to do that is to allow the real estate market to fall as much the free market will allow. Also, there are those taking advantage of the market by buying up these foreclosed properties. These are also vultures. By artificially stabilizing housing, what we are really doing is not allowing vultures to come in. Yet, it is the vultures that are necessary for any bottom and recovery.

The argument against allowing market forces to take hold is that such action would mean significant pain. Yet, I ask isn't that what we are going through now. For all those that say allowing these banks to fail would create a credit freeze, what exactly are we going through now? How much longer should the economy go through incremental pain before we all realize that we are all merely prolonging the pain. Propping up bad banks so that they can struggle to meet their own obligations with no hope of viability is not a sound strategy for any long term healthy economy. Propping up bad borrowers so that real estate prices can stabilize temporarily is not a sound policy for any long term healthy economy.

What this economy needs is a cleansing. It needs to be cleansed from all the waste and the excess. The only force that can create that cleansing is the free market. Once the economy is cleansed the next natural step is for the vultures to swarm in on cheap assets and take advantage. The only thing that can create that is to allow the free market to run its course. Such a strategy is painful, scary, and not very politically appealing. Yet, what are we going through now if not the same thing?

6 comments:

Anonymous said...

Mike,

First of all, maybe we shouldn't let one man, Greenspan in this instance, have so much power. Financial markets need stability. We one person is able to destabilize the market so easily, it is ruinous.

Second, doesn't it seem like our government financial experts are mostly from Wall Street/Banking and are really making sure their kind profit from this crisis or at least suffer less than the rest of us?

We are in deep trouble.

Lonzo

mike volpe said...

That is slightly off topic but I totally agree that the Fed has far too much power. On top of this, the Fed is very misunderstood by the public at large. That is the most dangerous combination.

Toronto Real Estate said...

Are you sure that allowing free market will solve this? I'm not sure about Mr. Obamas recovery plan either since just printing new money has never done anything but created more debt but free market just does not seem like the best idea here either.

Take care, Julie

PS: Nicely written!

mike volpe said...

I gave my reasons, so if there is a problem, you need to give me some specifics.Only the free market will unleash the vultures. Only unleashing the vultures will cause a bottom.

Toronto Real Estate said...

The problem is that the market would be flooded with weak business trying to take advantage of the cheap market situation. And it's a matter of time when the next crisis would hit just because all these businesses would eventually again bankrupt. Do you really need vultures to start up everything again?

Julie

mike volpe said...

The weak business will be started by loose money not by vultures taking advantage of deals.

Absolutely, you need so called vultures. That's because it is the vultures that restart business. When there is a downturn, you need those that say now things are bad enough that there is opportunity. Those are the folks that lead the market back.

Vultures are not necessarily weak. In fact, they are strong. They are the likes of Warren Buffett. They are also good borrowers that are looking for deals. Those are the folks that need to be encouraged to buy. Artificially keeping things in place won't encourage those folks to step in.