This was originally composed as a comment to a post on a friend's blog, entitled "The Next Great Depression? When Trust Vanishes, Worry". Unfortunately I can't seem to get a comment through to his site, so I'm posting it here instead.
When people talk about the banks being scared to lend, I have to laugh. I received two 0% credit card offers yesterday - and they were good, too, 0% for a full year. I haven't received offers like that since the internet bubble.
Are banks going to start looking more carefully at subprime mortgages? Yes, they are, and those mortgages are going to be harder to get. I'd argue that's a good thing, not a bad thing: if banks had been insisting on 20% down payments all along, like they used to do, we wouldn't have the mortgage problem in the first place. And even if the banks are making fewer mortgage loans, the money still exists, and the banks want to do something with it; thus, the credit card offers.
Now, banks might start tightening their loans to businesses, too. But here's the thing: even if they're buying treasuries instead, that brings down the interest rate on government debt, and thus reduces the deficit. Taxes can fall - or be prevented from rising - making it easier for businesses to self finance rather than borrow. The truly prudent investments will still be made. The "petfood.com" type investments might be out of luck, but I would argue that they should be.
Now, will we have a recession? I sure hope so. The economy needs a recession every now and then, exactly to squeeze out inefficiencies like overinflated internet stock prices, or overinflated housing prices. That's not a problem; it's a necessity. The recessions in 1980 and 1992 were needed to support the decades of strong growth that followed them. Trying to stave them off can do more harm than good, as happened during the period of "stagflation" in the 1970s preceding the 1980 recession.
All of those are reasons why intervention is not necessary. The question then is, can intervention do any harm? We can get a start on understanding this by looking at what's happened so far.
Initially, the "crisis" started when FNMA ("Fannie Mae") and FHLMC looked like they might be having problems. There was a proposal to inject $2.5 Billion into FNMA (which, Tom, I remember you as opposing at the time). To put it in more personal terms, that amounts to something like $30 for a family of four. However, Bernanke and Paulson decided to take control of the two entities instead.
Unfortunately, Bernanke and Paulson didn't do their homework, and didn't realize that this would trigger billions - possibly hundreds of billions - of dollars in mortgage based credit default swaps. This caused a liquidity crisis at AIG, perhaps the biggest insurer in the world with over $500 Billion in assets. Bernanke intervened again, this time loaning $75 Billion to AIG to prevent a loan default.
Now, a loan default isn't a disaster; usually creditors can work things out without it becoming a bankruptcy, and even if it were a bankruptcy, creditors would still have gotten at least 85 cents on the dollar, and more likely 97 cents, neither of which is so bad. However, for whatever reason, Bernanke provided the money, which this time amounted to about $1000 for a family of four.
Naturally, once you've bailed one person out, everyone wants assurances that they'll be bailed out too. That's why Bernanke and Paulson are asking for $700 Billion, almost a trillion dollars, which is what's in the news right now. That's about $9000 for a family of four; it's starting to add up to real money - especially for the average American, who might not be as affluent as the average reader of this blog. When it comes time to pay the piper, that's going to be a big increase in taxes - likely enough to cause a recession or depression bigger than what we're trying to prevent.
But is that the end? I don't think it is. The more people get guarantees from the government, the less careful they'll be about risk - and there's a lot of at risk money out there. How much?
$54 Trillion. That's the total amount of credit default swaps outstanding. It doesn't sound like much until you realize that's a "T" instead of a "B" at the beginning of "Trillion". And that's the amount the government is ultimately headed towards guaranteeing, if they keep heading down that path.
Now we're talking about $700,000 for a family of four. Can you imagine the average American family trying to work off that amount in taxes? It can't be done.
The government will be reduced to printing money to the point where it's worthless. At that point, investors aren't going to take refuge in treasury bonds - they won't trust them not to become worthless due to inflation - they'll take refuge in commodities, like the old standby, gold. Then the capital will really be out of circulation, unavailable for loans. We'll get to go down to the grocery store and try to barter our engineering services or legal services for food. That won't work too well.
That's what the worst case economic scenario really is - and that's where the bailout is taking us. Fortunately, we still have a chance to say no.
On October 2nd, 2008 02:12 pm (UTC), (Anonymous) commented:
I don't feel like I completely understand what the problem is. These subprime mortgages aren't worthless. Not all are in default, and they are collateral back loans, so the lenders ought to be able to get some of their money back through foreclosure - so some money is being lost for sure, but it seems like there is still value there.
I thought some of the problem was liquidity, since the are either hard to assign a value or hard to sell?
I do agree that once we start bailing people out, everyone wants a bailout. Including the homeowners that are losing their homes.
And I also agree about removing the penalties for risk being a BAD thing. It does seem like we need to let this all work its way out of the system, so to speak - but is there a way to let it unfold slowly?
I have to admit, what I have read about the current bailout proposal scares me.
I think you actually do understand pretty well. There is no fundamental underlying problem: as you note, even a foreclosed mortgage is generally worth most of its face value, and most mortgages that are in default - which is just a month or two of delinquency - do not result in foreclosure.
Some of the derivatives, including the credit default swaps, are slightly complex, albeit but nothing a bright high school student couldn't understand. The "hard to assign a value" and "hard to sell" things are, I think, largely red herrings; what they mean is, "I don't want to assign a true value and sell them at that, because that would require me to write them down on my books, and the stock market would punish my company's stock for that, making my executive stock options worth less". Writing down a mortgage portfolio by even a couple of percent is enough for the analysts to take note. However, it's nothing that some honesty won't fix, as has been noted by the CEOs of some of the better managed banks and brokerage houses.
Liquidity can be an issue. Most banks have a longer average term on their loans - for example mortgages - than on their deposits, much of which can be withdrawn at a moment's notice. If a rumor goes around that a bank is going to fail, there may be a "run" on the bank - that is, depositors may rush to withdraw their deposits while they still can before the bank fails. Given time, the mortgage payments would cover those withdrawals, or the mortgages could be sold to cover them, but the bank might not have enough time.
That's what the FDIC - Federal Deposit Insurance Company - was establised to prevent. By insuring most deposits, runs on those deposits are less likely.
Now, it's true that the FDIC limits haven't been raised since 1990 or so, while the amount of money people have in their bank accounts has increased substantially. What happened with Wachovia was that, in addition to some questionable mortgages (a mortgage type called "pick your payment" can't be good), people with more than $100,000 in deposits started withdrawing their excess money to get under the insurance limit.
But you know what? No special bailout was needed for that. Citibank spotted the opportunity to make money by providing the liquidity, and bought out the banking half of Wachovia. The brokerage half is still independent and seems fine. The FDIC provided some help, but within their existing authority; Congress didn't have to do a thing. The system works.
Now, I do think it might be time to adjust the deposit insurance limit upward. (And Dave, if you're reading this, that's an update to my answer on what alternatives might be good.) I really don't think new powers for the Treasury secretary or any new authorizations of money are needed, though.
On October 3rd, 2008 02:29 am (UTC), (Anonymous) commented:
(This is Tom N.)
I don't think I said in my blog post that we *should* have the "bailout," I just pointed out that we would likely have a depression if it wasn't passed. I'm of a mixed mind about it. On the one hand, John Mauldin (an investment advisor whose opinions I generally trust and understand, and who is generally very much a free market kind of guy) says that something like the bailout is needed because otherwise businesses will have their lines of credit closed down (something which has already started), which could have lots of bad consequences throughout the economy (including very high unemployment). On the other hand, I do agree that moral hazard is something to be avoided.
Right at this moment is, to me, the starkest realization of the brink between super-inflation and deflation I've felt we've been on for the last couple of years. By some measures, we've had high inflation. By other, things have been deflating. As the credit bubble collapses, we should get massive deflation. But there are so many pressures for the government to print money to get itself out of the hole we're in, that at some point we should see large-scale inflation. If you believe we'll have inflation, you should buy gold. If you believe we'll have deflation, you should hold cash. But which will it be?
You did not actually say we should have the bailout, and I apologize if it reads like I thought you did. The article you linked to basically did say we should have the bailout, and to a large extent it's that article I'm responding to here.
One thing that we need to recognize here is the distinction between a recession and a depression. The cycle of excessive lending, loans going bad, credit tightening, layoffs to reduce costs, improved profit margins, and hiring again is the normal business cycle - that describes a recession, not a depression. Recessions are okay. The economy needs a recession now and then, and we shouldn't risk our future and our childrens' future to avoid a couple years of pain.
Depressions are different. There, people lose their jobs and never go back to work. There's more to a depression than a recession; there are fundamental shifts that economically disenfranchise entire generations. Depressions are not just big recessions.
So one thing I would ask of your friend is whether, when he's thinking of "high" unemployment, he means 8% or 80%. Anything under 10% and he's just thinking about a recession. Over 20%, and it might be a depression, at least in an industrial economy.
By the inflation measures I watch - primarily CPI inclusive and exclusive of food and fuel - it's been creeping up under Bernanke, and more than creeping this year. It hasn't been high enough for long enough for inflationary expectations to really set in, though. That is the biggest inflation risk, because once those expectations are set, it's very hard to rub them out. Which measures have you seen that are actually deflating?
I've been thinking about a post I've been planning on how depressions work. While discussing it with my wife just now, though, I realized that my thoughts - maybe our thoughts - were morphing from "here's some things that are common to various historical depressions" to "here's how those various things fit together". It just seems so obvious now that I can't believe no one has put it together before, though; I feel like I must be missing something. I feel like I need to bounce it off more people to see what I'm missing - people like your wife, and others who may be familiar with the agricultural depressions of the 1800s.
Um, does this post mean you're not the anonymous that posted above?