Tuesday, February 10, 2009

Bad Assets are not the Problem

I've grown extremely frustrated by the rush to save our nation's banking system, because bad assets are not the real problem. Yes, some plans, such as the nebulous cloud of something that Geithner proposed, are indeed worse than others. But even nationalization will not itself trigger credit creation or lending. We're wasting precious time answering the wrong question.

Bernanke(whom I think very highly of, even when he screws up) stated this bluntly in his testimony today, though he's said it before. He said lending is -- my rough transcription -- "no longer frozen because of subprime mortgages and bad assets, but fear about where the economy is going."

This should be blatantly obvious, but everyone's missing it and arguing about who gets screwed. Meanwhile, loans are not being extended because it makes no economic sense to borrow or lend at current interest rates with current default risks. Here's a multiple choice question to illustrate.

You are an insolvent bank. The Treasury and Fed offer you virtually limitless amounts of liquidity at nearly zero interest rates, and even give you some cash for trash. You are now flush with excess reserves, even while securities trade in the secondary markets that bear record wide yields to Treasuries. You could receive 10% interest and expect 5% loss to defaults. Do you:

A) Hoard your cash as a poor man's loan loss reserve in anticipation of future defaults;
B) Lend your cash as fast as possible in hopes the spread will fill the hole in your balance sheet.

We know the banks' answer, so in the current economic environment, apparently the return proposition sucks. Now let's add that the Fed is buying securities outright to push down interest rates. You now receive a smaller spread, and also suspect there might be an outburst of inflation triggering the Fed to crank the FFR. Does your answer improve?

Nationalization and recapitalization don't make lending more appealing. Haggling over who has to eat the carcass is important in terms of loss distribution, but it has no chance of increasing credit creation or economic growth, because it does nothing to improve the fundamental economic realities of money creation. It's a horrible, useless distraction.

Until America becomes more competitive through real devaluation of some form, and the claims on debtors are lightened through bankruptcy, things will continue to deteriorate.


Anonymous said...

As usual, thank you for your clear thinking.

The bank recapitalization issue is directly relevant to the US leverage situation because the US financial sector has roughly $15T in debt outstanding (accept the uncertainty in that number for now). A debt cramdown of the major zombie banks as part of a nationalization, combined with the ongoing deleveraging of the healthy portion of the banking industry, would meaningfully contribute to the US deleveraging process. Stasis, however, as promoted by sketchy, dubious federal initiatives, prolongs the US debt problem in one criticial sector.

That's a slightly different take on things, I hope, and explains why the reaction in the US debt and equity markets yesterday was rational.


ndk said...

A debt cramdown of the major zombie banks as part of a nationalization, combined with the ongoing deleveraging of the healthy portion of the banking industry, would meaningfully contribute to the US deleveraging process.

First, thanks for commenting again. :D

Debt cramdown is a key to solving this problem, jult52, but it is tangential to our current dilemmas. It could very well happen in bankruptcies or in recapitalization, as well.

Nationalization could make cramdowns more likely, but they still would come only at the cost of increasing government indebtedness as it seeks to keep the liabilities of the banks it assumed, like bonds and deposits, intact. As Buiter and Wolf have rightly harped on, we don't have a good Federal balance sheet to work with in the first place.

Indeed, the taxpayer seems likely to take the hit from cramdowns instead of creditors and depositors no matter whether the banks are privatized or not, which might be good and might be bad.

But this discussion -- how to perform the major cramdowns you describe -- is one of the important discussions we should be having right now, instead of hoping that buying the bad assets or nationalizing the banks will help. I happen to think bankruptcy is the most expeditious way, but I could be persuaded otherwise. I can't be convinced that nationalization or Geithner's plan represent, alone, any kind of answer.

Donlast said...

Yes, a very good point but is it not a case of cleansing the body. The big banks are probably insolvent. They are like an ulcer that has got to be treated otherwise it just festers.

Getting banks to lend, well, if there are any bankers out there who have the hots to make lots of loans they should be told to go and lie down in a quiet room until the fever passes.

ndk said...

Yes, a very good point but is it not a case of cleansing the body. The big banks are probably insolvent. They are like an ulcer that has got to be treated otherwise it just festers.

I think you're right on that there needs to be treatment, Donlast. The trouble is, I don't think we're invoking the right treatment. Buying the bad assets or nationalizing the banks is just the surgeon grafting the wound onto his own body.

The bad loans are still there; the misallocations of resources persist; and borrowers still struggle under the debt load they can't repay. Cramdowns and defaults strike me as the penicillin we need.

As every banker in today's testimony uniformly ruled out cramdowns as a solution, maybe nationalization is a prerequisite for cramdowns.

But nationalization simultaneously makes default less palatable. How can the government suspend credit cards or foreclose without inciting serious unrest?

Either way, I think this conversation -- how to safely destroy a lot of bad credit -- is the right one to have, and I thank you for participating in it. :D

think like a trader said...

Banks want to lend and they also have money to lend. The only problem is fewer worthy borrowers there. My wife just bought her third house for rental income. She has no problem to get a loan from Well Fargo. ( 20% down, 6.25% 30 year fix)

For those who don't understand what's really going on, I suggest them to think about the economic effects of the demographic change in our society and many answers can be found. To start with, take a look at wwww.hsdent.com .

As for the banking problem, have to go the path with the most efficient way to preserve capitals (I mean to preserve taxpayers' capital) so that the government still have resources to tap on for the terrible years to come.

We are in a very dangerous stage. There is a high chance that those policy makers could screw up things badly.

Detroit Dan said...

I agree with ndk, as usual. That's why I'm here. We need to write down bad loans, accept the losses, and devalue the currency so that our trade deficit will continue to shrink. China will have to accept the losses on its investments in U.S. Treauries, and accept the fact that they cannot to continue to export their way to prosperity. These things are inevitable and the sooner the two countries face up to the facts, the better.

We've taken the first step by throwing out the Republicans whose so called conservatism is a straight from fantasy land. The Dems at least realize that the health of the economy depends upon a middle class that earns a decent wage and has a decent safety net. Now if we could just get them to realize that we shouldn't encourage people to live beyond their means...

think like a trader said...

What Detroit Dan said in comments is pro protectionism. However if we halt trade, the result will be even worse. The trade deficit is a very smaller problem. China's trader surplus is not the root cause of our current crisis. Remember all the dollars China has have to buy things in dollar terms. If US chooses any moronic policy like weak dollar, China could simply sell off all their treasure holdings and buy commodities all over the world. And they are doing it now. That will bring US interest rate to double digits level and also bring high inflation to US. That will be the end of US prosperity.

Sometime I just don't understand why people can't think in dynamic way. The world is not static. Any policy that aims to benefit one side and hurt the other side will generate conflicts. A policy can only be considered good when the net benefit is much larger than the loss generated from the conflicts. China is helping US now and US is more than ever needs that help. I strongly believe a weak dollar will hurt US more than China.

The jobs lost to China are mostly low skilled jobs and as long as there is trade, that can't be avoided. The problem is how many workers in US really have much more skills than their Chinese counter party who get paid maybe just 1/20 for the SAME work that paid here.

The anger and frustration against trade mostly come from workers who don't really have much professional skills. The solution is not to ban the trade but a realization for the workers no matter where that if one does not keep learning and keep expanding his professional skills there will be no job for him.

Anyone who was born in a wealthy country does not mean that person is entitled to a better life if he basically has no damn skill to make a living and has no desire to learn so.

purple said...

A big time-bomb coming up is student loan debt. Americans under 35 simply have no money to sustain a consumer- oriented capitalist economy. And the students with the most education and skills have the most debt.

Detroit Dan said...

A weakening dollar is the logical result of a persistent trade deficit. think like a trader is not thinking like an economist, in my humble opinion...