This diary augments my earlier Crisis 101 diary.
It is a primer of sorts that examines some of the cause and effect dynamics at work within the economic crisis we face today. It hopefully looks at some of the problems in a way that helps build a clear understanding of what went wrong, what sounds wrong, and what might be a better way to deal with what looks like the beginning of a bad recession.
If this is an economic crisis, why do we focus on the stock market?
Under normal circumstances, the market is a good leading indicator for future economic activity. In theory, it is only an indicator and has very little direct influence over the broad economy. The stock market suffered a crash in 1987, but the economy barely noticed. The market actually posted a gain for all of 1987.
The market's behavior so far most closely resembles the 1929 crash, but so many indicators are setting records, that historical comparisons are almost meaningless. So far, 6 of the 20 largest point drops in the market have occurred in the last month, and 3 of the 20 largest point gains have happened in the same period. Viewed another way, record dips are happening 1000 times more frequently than average, and record gains are happening 500 times more frequently than average. Last Friday, the measure of volatility called the VIX set an all-time record. The market is down 40% from one year ago. There is a reluctance to read anything specific into this extraordinary behavior because these events are not caused by normal business-cycle indicators.
There is definitely a negative disturbance in the force, and it appears to be feeding on itself. There was a fundamental imbalance in the economic business cycle that at first appeared to be a mild recession correcting for an overheated real estate market. It was actually a stock market event that began to flush out the extent of the problem, and help create an even bigger problem which is now affecting the broader economy.
It started with Bear Stearns, but the whole cycle can be best viewed for its purity and brevity by looking at the Lehman. The bankruptcy itself was blamed on a stock market activity called short selling, or shorting a stock. This is an act which allows someone to make money on the decline of a company's stock price. The mechanism is not important here, but there is a theoretical way to drive a distressed company into bankruptcy by shorting its stock; this is often referred to as a short squeeze on a company.
Lehman made exactly this claim about the cause of their demise, and they cried foul. They may have the cause correct, but to cry foul is pure bullshit because Lehman failed to fully account for their assets and liabilities. They claimed everything was roses but the short sellers could smell the garbage underneath. If Lehman was solvent, then they could have sold assets and purchased their own stock and actually punished the short sellers and made money in the process.
It was a shame they didn't have any assets they could sell. In this sense, the short sellers forced the true valuation of Lehman, which was zero, and bankruptcy resulted. The powers-that-be hated this and a ban on short selling financial stocks was instituted. This ban is suspected of being very costly as it deprived institutions which protect investments, an important tool to hedge against loss. If nothing else, the action certainly preserved the distrust of financial company valuations.
In my opinion, it also tipped off the government's awareness of the deep distress within the financial industry - an industry the government was supposed to regulate so something like this didn't happen.
The market action on Lehman had the effect of really driving fear into these companies not only for themselves, but fear of any institution which held the same type of investment vehicle as Lehman - the mortgage- backed security, or MBS for short. All the financial institutions held them, and the result has been an increasingly worse lockup in credit because none of the banks want to lend money to any other bank for fear the other party may be next to fold.
One major difference between the stock market and the economy is that the market is very sensitive to fear and euphoria. Investors tend to pile on to a good thing, and flee bad things. These actions can feast on themselves and raise the general level of nervousness. Market volatility is extreme right now, and many of the indicators are off the charts. Market players are jumping out of their skin. Everyone is trying to convince themselves that the are seeing a bottom to the market's decline, but it still marches down. The perma-bull cheerleaders on the financial networks are about the only thing that has capitulated; one of the biggest TV cheerleaders finally told everyone the other day to take enough out of the market to cover their cash needs for 5 years. I don't think he ever told anyone to sell a stock before.
This is one of the very rare moments where market fear has spilled over to the general public - enough so to aggravate the credit crunch by causing banks to hoard cash in the event of an actual bank run. All the factors together causing the credit crunch are now affecting the broader economy and depressing stock prices across the board.
There is now a general sense of fear from all directions, and every time the government announces a new radical action to solve the crisis, it acts to confirm things are getting worse. Maybe they ought to just shut up.
Why is credit so important? Doesn't anybody have cash?
It has nothing to do with that; you have to look at history and the roll credit plays in society.
Wealth is created through efficiency. For example, farming and raising livestock is more efficient than gathering berries and hunting. Like food, knowledge is an asset too, and teachers are sort of like brain farmers. With care, both are self-sustaining and will pay dividends over and over. Refrigeration is another thing that improves efficiency; it eliminates waste by preserving dead meat. Penicillin does the same thing, only with living meat. These are just a few examples of how efficiency improves our standard of living and quality of life.
Currency is another invention to improve efficiency. It acts as a universal asset to be traded with any other asset - including labor. Universal currencies are very popular tools for efficiency. The law is a universal currency which exists to keep the exchange of assets a zero-sum trade. If a price is agreed to by both parties, but one party fails to hold up their end of the bargain, the law notes the difference, attempts restitution, and charges steep interest to dissuade the same behavior in the future.
This even exchange of assets seems fair at face value, but if we only traded with assets at hand, there would be very little upward mobility for most of society. Trading in full, at fair market value can rapidly separate society into castes. Those with assets will quickly overpower those without assets in nearly all aspects of society. A farmer with a tractor will dwarf a farmer without a tractor in just a couple of years. The farmer without the tractor would never even get off the ground because his efficiency could never deliver the food prices the tractor would help deliver. If the farmer without could get a tractor on credit, he could be competitive right away, and through competition, he would help ensure the market obtained the lowest price for goods.
Credit is literally borrowing from your future self, but it requires a neutral party to facilitate the exchange. Credit allows more and more working capital to be obtained in the present by borrowing longer and longer into the future. You can obtain enough capital today to purchase a house by borrowing against 30 years of your future working capital. Credit accelerates and intensifies trade. If used properly, this can turn into improvements to our standard of living. The benefits of credit are huge. It is an efficiency multiplier, and that especially includes time. Despite what the government and advertising says, credit should never be used for shit you don't really need.
What are the downsides to credit?
Banks have to be careful to evaluate as many factors as possible which affect the risk of making a loan. They have to ensure they are compensated, on average, for all risk taken. If the bank itself has any debt obligations, then it has a duty to notify its creditors of the additional risk they will assume from the bank itself taking on new risk. Banks typically compensate for this additional risk by offering interest to its creditors in direct proportion to their exposed risk. The system breaks down if risk is improperly calculated or improperly passed along without compensation.
Banks will first attempt to mitigate risk by demanding a down-payment or by holding a lien on some asset owned by the borrower. If the loan is for the direct purchase of an asset, the asset itself may be considered as collateral, as is the case with mortgages.
Even if everything goes well with the loan, the bank is still exposed to the risk of inflation. In fact, the loan itself contributes to inflation in its own small way. Credit effectively increases the current supply of money, and when the supply of money increases, it has the effect of raising prices. To understand why this is, pretend the government gave everyone $1 million dollars; people will spend a portion of this extra money on things they desire. This might cause an increase in demand for a particular product which will cause an increase in the cost to manufacturer the product to meet the demand. Factories will have to pay time-and-a-half for overtime, or maybe build expand its operations to keep up with demand. Since demand is high, they will pass this cost on right away to offset these costs. The general trend in a stable economy is always for prices to rise, so that today's dollar buys more than tomorrow's dollar. This can have a huge impact on a business with thin margins if inflation is not accounted for.
Everything has to be done carefully and honestly for the credit system to work, and this means complete transparency in the process. The bank needs to know if the borrower has the ability to pay back the loan, and this includes discovering any other creditors the borrower might have. The bank cannot expect to be first in line for payment without the other creditors agreeing to that, and it cannot expect the borrower to forgo basic necessities to repay the loan. The bank wants to lower risk, not increase risk.
As outlined in Crisis 101, lenders involved in the current crisis were perversely encouraging risky loans. The lenders were repackaging the debt in fancy ways that did not properly reflect the underlying risk. This fact was hidden at first by the asset bubble the lenders themselves created by increasing the money supply directed to the housing market. The way the high-risk mortgages were structured actually increased the risk of default after an initial, affordable 'teaser' rate reset to a higher rate later on. The loans worked as long as the bubble didn't burst - something they always do.
Now, not only were the lenders being deprived of income streams that erased any profit being made on the lend/borrow credit spread, but the complex bonds they were selling were in part valued against collateral (the deeds to the houses) which was losing value - collateral was shrinking, but the size of the loan wasn't. All the big banks and investment funds were holding these instruments that nobody dare value and nobody could sell. Alan Greenspan used to brag about these instruments and say that they smeared out risk, but because the risk assessment was flawed at best, or fraudulent at worst, what they did is smear around distrust.
Will the bailout work?
Work for whom?
The initial plan to buy up the toxic crap that the big banks own was a disgusting top-down approach of solving the crisis. Paulson should be drawn and quartered for even floating it. The idea was to provide the banks with working capital while at the same time removing big chunks of distrust from bank balance sheets. The distrust exists because of the unwillingness on the part of the banks to make a market for their distressed assets by reducing the asset value until they become marketable. They are doing this with the full assistance of the government because if they are forced to discount to a price that would sell on the market, then they would be bankrupt.
If by some chance this form of bailout worked, then it will have done so by effectively re-inflating the housing bubble so only the banks can enjoy the rewards of selling assets at that level. They would be doing so fully at the expense of the taxpayer. In addition to servicing banks, the Fed recently opened up their discount window to non-depositor banks such as brokerages and other lenders and financial institutions. The Fed also extended the loan duration through the window from overnight to 90 days, which allows them to rollover debt and prolong their death struggle and their hoarding ways. I can see no qualitative difference between financial institutions and any other corporation, except any other corporation is probably more solvent and certainly more honest and deserving. Any company that is being hurt by difficulty accessing revolving credit or commercial paper should be eligible for the Fed window, and the Fed could do that right now.
Another problem with purchasing toxic assets is that the amount of money Congress has approved is only enough to purchase maybe the sub-prime securities and does nothing to address the other $5.5 trillion MBS's that are losing value and becoming distressed too. They have already snuck in a $40 billion per month troubled asset purchase facility through Fhonie May and Fradie Mac.
The only thing that will stabilize the further erosion of the MBS's is by having every home and office park occupied by paying mortgage holders.
It is extremely doubtful that housing will lead us out of this recession which is for all purposes, just getting started. There are plenty of indicators suggesting it could be quite deep with some jarring dips. For example, we have to wrap our minds around the fact that Ford and GM might not survive. This will impact the full vertical gambit of markets that service the auto industry - everything from steel plants to car dealerships.
Given the reality of the recession, spending at the top could prove to be very costly since we could be looking at the possibility of having to spend it at the bottom anyway. People are going to need jobs, or they are going to need food, clothing and shelter.
The government is now talking about altering the bailout plan by purchasing stakes in the banks along with buying the toxic crap. The thing is, they have to do this fast, and unless they purchase 51% of the banks, they will not be able to force the banks to lend. The only thing it will do is dilute all the investors. It increases moral hazard and lowers the reluctance of bank officers to raid on the way out. Nothing about it ensures a fix either - it is all just a gamble by Paulson, and his record at the craps table is open for all to see.
The traditional way out of bad recessions is through exports, and we are not making any moves to improve our ability to manufacture and export. I have no idea to the exact degree, but I sense that globalization has put us at a real disadvantage in this area.
Given the rate which the government has been willing to print money for this crisis so far, and given that we are already deep in debt, once there is an uptick in the economy, we will have to pull hard on the reigns to keep from entering a severe inflationary period. That means other countries will probably be poised to recover faster than us. The world could end up flooded in dollars, and countries who thought their pile was something special will be pissed. Pissed enough to hurt our ability to trade, and maybe even pissed enough to let loose a few missiles at a warship or two of ours. China has spent years climbing to the rim of the first-world plateau. If our actions are not in line with their best interests, and we are in a vulnerable state, then we may find out we are not so exceptional after all.
What if this last best hope doesn't work?
Then we stand in line for meals of Soylent Green and wait for Pelosi to ship us government-supplied work boots that are made in China. We can wear them to our new jobs running from line to line signing up for jobs that don't really exist.
So, what might work?
I'm not qualified to answer that, but here is a video of a guy who probably is. Last year, Nouriel Roubini outlined a 12-step process that could lead to the situation we are in right now. Others can claim they saw it coming too, but this guy gave specific events that he saw as likely and warned of the dangers. One thing that he probably can't say for political reasons is that Paulson was incubated in the very system he is trying to save. I know we are supposed to believe Paulson is impartial, but we are also supposed to believe he never saw this coming too. Roubini should be heaping scorn on Paulson, but that might be a bad career move for an economics professor.
One of Roubini's remedies is for Paulson to draw up a list of the banks that are deemed solvent and shut down the rest. It makes sense to me; in fact, if the only bank left standing were the Fed, then it could do everything that it wants to do monetarily without having to rely on the cooperation of other banks. Let the banks fail, and suspend indefinitely the CDS contracts - they won't be needed anyway. Leaving half the big banks standing in a wobbly state in the middle of a recession actually sounds dangerous to me, given their inability to look past their own self-interest. I don't see how a bunch of banks can fail while leaving the CDS market intact. I don't see how forcing them all to stay solvent is feasible either; not without making life miserable for the next 3 generations of our children.
Is there nothing else?
Sure there is; I don't know this for a fact, but Roubini might be viewing this whole thing at a professional level and staying within the sterile bounds of an economist.
I'm not sure if a modern economist can call for a Keynesian plan B without ending his or her career. To me, it would be like a preacher recommending we try the devil since God might not be listening. I'm exaggerating, of course.
This is just a personal opinion, but the US could start right now with a bottom up attempt at fixing the economy. It will be the last time for a long time to work on the infrastructure.
We could be working on a plan right now for the construction of a high-speed mag-lev bullet train which links every city in America. Further, this train could be powered 100% by green energy generation projects. It is probably the only way to take a shot at besting China's awesome supply chain infrastructure. We could build cargo-only train lines which run down the middle of planned total-industry corridors designed to take raw materials in at one end, and spit out boxed, finished products for consumption and export at the other end. Living 100 miles from work would mean nothing if a train gets you there in a half hour. GM or Ford could get the contracts to build the drive trains, and some other company that actually shows good aesthetic taste could build the passenger compartments. Anyone in the world who has a product that could benefit from plugging into our utra-efficient supply chain and (hopefully) inexpensive and green power source is welcome to set up shop along an environmentally controlled industrial corridor. We will handle your waste recovery and reprocessing - you won't.
Maybe someone here might have fun running numbers on this kind of a project just for giggles.
A railroad once kept people employed from coast to coast in this nation. Don't tell me it can never happen again. What the hell else might there be to do if things start coming unglued? The projection is for this recession to hit the globe. How each country uses its down-time might prove to be important. I hate the idea of throwing good money after bad to save a handful of banks. There will be new banks.