Tuesday, April 08, 2008

The Market or The Fed? We'd Better Decide

Bank holding companies including Citigroup Inc., Bank of America Corp. and Wells Fargo & Co. have the thinnest safety cushion against losses in seven years...Credit ratings on $704 billion of bonds have been cut this year following the collapse of the U.S. housing market. Sheila Bair, chairman of the Federal Deposit Insurance Corp., said last week that the downgrades may compromise bank capital ratios enough that some of the largest institutions will no longer be considered well capitalized....Falling below a regulatory benchmark that is intended to maintain a minimum level of capital to protect depositors against losses would subject banks to more scrutiny from regulators than they have ever experienced....Citigroup, Wells-Fargo May Fuel Recession by Curtailing Lending, Bloomberg.com, 4/8/08

It's that big, folks. As noted below in remarks about Senator McCain's thoughts on the subprime mortgage mess and the consequences of a panic, markets respond swiftly and efficiently. Government intervention causes increasingly dangerous problems. Why is this important?

As Fed Chair Bernanke's ill-advised bailout of Bear Sterns demonstrated, the only way for the government to rescue a badly managed institution is to print money, to paper over a financial collapse. When you do that, as time-honored a practice in Argentina as in recent years in the US, you devalue the currency. How? When value doesn't change, but the dollars that represent it increase, the dollars become worth less. That TIAA-CREF account you have that's valued at $700,000 -- check again after one of these bailouts. It may be worth ten percent less, even though the numbers stay the same. The Bear Sterns story isn't over either. Class actions suits by shareholders in both Morgan Chase and Bear Sterns are highly likely. Why? When the government intervenes to force a deal, as the takeover of BS by Morgan Chase, it sets a price which may not be indicative of real value. The Fed allowed a valuation of Bear Sterns at $2 a share, down 95% from the previous week's listing on the exchange. A little welcome flexibility got that up to $10 a share, which may put off the legal threat, but don't count stockholders out yet. Lawyers feed off this kind of thing.

The market, in Citibank's case, reinforced by regulation on capital reserves, has sent a clear message to borrowers: if prospective borrowers don't have strong collateral, long-term stability, and a substantial down payment, don't issue any paper to them. They are not creditworthy in today's market. It's an honest assessment. The Fed can't help this. That was $704 billion in questionable paper, a big chunk of which is in the hands of Citibank and Wells Fargo. Questionable paper, for all intents and purposes, may as well be toilet paper for all the value it has as an asset. If things get worse, this questionable stuff will become an expensive writedown. Then, policy trends by lending officers will become official bank policy.

These things happen. Take a smaller example. Let's say that, feeling flush after a big raise, you borrowed $82,500 to buy yourself a new Escalade. Then, eight months into the sixty-month payback schedule for the auto loan, you discovered that you couldn't afford the payments. Hey! you complain; I can't help it. Well, the people's whose jobs depend on your paying back that $82,500 loan don't have many options here. You've taken $82,500 out of their capital, which you've agreed to pay back at -- these days -- very modest interest. Now you won't meet the payments schedule. What choice do people have whose livelihoods depend upon you making responsible use of their depositors' money?

You guessed right. They send repo man. They sell the Escalade and get back maybe fifty cents on the dollar. It's not a great system for the bank, but at least they got half the money back and can loan it to somebody else. That you might have to drive an old Plymouth for a while isn't their problem. If you'd paid attention to something real in budgeting, you might have bought a Voyager instead of an Escalade. The problem here is that if they let everybody off the hook who didn't pay back auto loans, there would be no money to loan to buy cars, no employment for loan officers who issue auto loans, and layoffs at General Motors.

But wait! Here come de spitzer! (see below). The spitzer says that this loan payback business is immoral, and that you, the poor citizen, were victimized by the Satanic car salesman, who convinced you against your will to buy a car that you couldn't afford. The spitzer says "let the taxpayer buy this man's car." Or house, or factory...you see where this is going.

Once you start down the road of what's called moral risk there's no stopping. The more forgiveness there is of bad credit, the more dollars will be dumped into the economy to paper over the bad debt. The more dollars there are in circulation without an increase in value (such as paying back loans) the less those dollars will be worth. Inflation, back to the 1970s! Everything costs more and what you thought was your retirement (or house or vacation) fund is worth a lot less. Let's be honest here. This kind of "forgiveness" is nothing but government theft, transferring taxpayer money to settle accounts for people who refuse to do it on their own dollar.

Back to the real world: a lot of buyers and mortgage brokers suffered irrational exuberance in the last five years. Prices and the instruments for financing them became mindboggling. Houses that were on the market in Brooklyn for $50,000 in 1996 were, for a time, valued at $900,000 in 2006. No equity loans? What's the difference between that and rent? And what's the incentive to stay for the "buyer"? Whacko thinking! Deranged financing? Tulip market redux!

We know why this happened. It was exciting. Everybody would own something. And nobody in the banks or among buyers wanted anyone to be disappointed. This was America, where nobody ever loses. Fantasy can't be sustained in any real world. Sooner or later, the market has to be adjusted to actual conditions. Hope is not enough. A lot of people can't afford these amazing prices and the saner bank officers will have to start looking at the real basis for financing credit. A good place to start: the introductory rate on a mortgage, dear lender, and dear lendee, is not a basis for budgeting next year's monthly payment. It's a sale price for the first year. The lesson always comes and it is always harsh. Contracting the mortgage market by raising standards is how this lesson is taught.

The alternative of the kind of intervention the Fed engaged in with Bear Sterns, though, is a debased currency and the risk of explosive inflation. Want to go back to the 1970s? Want your retirements accounts to decline in value by 10% or more a year? That's what Citibank and Wells Fargo, by responding to real conditions in a real market, are trying to avoid. Unfortunately, the spitzers and the Fed, during an election year especially, don't want us to remember what happens when you pour good money into a pool of bad debt.

In sum, in this election year, we're faced with spitzer promises that could sink us in stagflation for a decade, or a few years of rocky roads as credit markets recover and credit standards are constructed along more rational lines.


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