Credit Crisis: What Should We Do?

The credit crisis that began in 2007 and triggered the current turmoil is unique in its ferocity, especially because so many large companies are experiencing unprecedented credit and liquidity problems. This all started with steep declines in home prices that decimated the value of mortgage collateral held by many banks and financial institutions. The abstruse complexity of those asset-backed securities held as collateral made it impossible to judge the strength of balance sheets. When investors realized balance sheets are unknowable, they started selling and many were forced to sell because they could no longer borrow to hold their positions.

Now everyone is deleveraging at once, and volatility has increased dramatically. We may not see anything like this in a very long time, perhaps in our life time.

Reflecting on the dramatic developments of the last few months, we note the landscape has changed significantly. Consider: during the third quarter alone, Fannie Mae and Freddie Mac were nationalized, Lehman Brothers filed for bankruptcy, insurance giant and Dow component AIG (one of the most important financial companies in the world) failed and was essentially taken over by the US government, major banks Washington Mutual and Wachovia collapsed, and Merrill Lynch was forced into the arms of a more solid bank. Investment banks no longer exist in the form they did before, as the two survivors Goldman Sachs and Morgan Stanley elected to become bank holding companies rather than investment banks, in exchange for deposits (this change has meaningful ramifications, among which are much smaller asset base and reduced future profitability, as well as increased regulatory oversight). And these are only the major companies. Scores of smaller financial institutions were swallowed whole by this storm, and even money market funds now need guarantees from Washington as part of a bailout package the size of the GDP of the Netherlands.

What brought us to this point? Low interest rates and easy money fueled greed and a speculative run up. That was aided and abetted by leverage and complex financial instruments that magnified leverage. Everyone is guilty of greed, not just Wall Street but also the home buyers who wanted more home than they could afford, and over-paid and over-borrowed to get it.

The confluence of those factors led banks to insolvency and everyone else to a loss of confidence. Loss of confidence leads to credit being halted. As British Prime Minister William Gladstone observed, "when panic awakes, credit sleeps". And credit is the life blood of any modern economy.

So what do we do now? Mathematician Carl Jacobi used to recommend thinking problems backwards, saying "invert, always invert". I would therefore like to focus on what we should NOT be doing:

• Do not open the spigot to infuse more liquidity. This is not a liquidity crisis but a solvency crisis precipitated by leverage. Banks are failing because they are insolvent. Large financial institutions collapsed because of irresponsible lending, shoddy risk management practices and an untenable business model that lasted for a long time but was recently exposed as disastrous. Liquidity alone will not solve this fundamental problem.

• Don't ban short selling. Price discovery is an important feature of free markets. Without short sellers the markets will not be as efficient and will not be as credible. The effort to ban short sellers is a desperate attempt to deflect attention from the real culprits. It does not go to the root of the problem but deals with the symptoms. Companies are not weak because of short sellers. Short sellers pick those companies because they are weak.

• Don't change accounting rules. Mark to model is by definition a rosy colored approach. We need to recognize our problems so that we can solve them. The proposal to suspend mark to market accounting reminds me of the 19th Century congressman from Indiana who wanted Congress to pass a law defining the value of Pi as 3.0 so kids in Indiana have an easier time memorizing it. Sweeping the trouble under the carpet will not help. It is never a good idea to ignore the truth, and reality isn't that bad that we have to hide from it.

• Don't inflate the Dollar by printing money. This is a short term fix with massive and painful long term consequences, and it does not serve the interests of the American people to have a weak currency.

The markets will do what they always do, which is find a new equilibrium point. The aggressive action by the Federal government will build confidence back up. Of course we do not know when that will happen. Headlines are likely to remain unpleasant for a while. But one of the great things about this country is that we have coping mechanisms and we deal with our problems. This storm will pass. Remember that markets typically bottom when pessimism is at new highs.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment partnership.

Comments

[joebhed]

Americans will lose TRILLIONS, their jobs and their houses, true.
But hey, this is their system.
Business cycles and all that.

Headlines are likely to remain negative for a while.

But, the storm will pass.

Then we can start all over again.
Cheap money, greed, irresponsible lending, shoddy risk management practices and an untenable business model.

And then we can do it all again.

And, again.

[BuckarooBanzai]

How about asking the real question here...............Can Paulson and Bernacke be trusted to fix this? Do they know what they are doing. All indications are pointing to "NO".

[doogiedude]

I agree, particularly since they both were saying the economy is fine a month or two ago.

Just sayin

[doogiedude]

It appears the government bailout plan addresses only the supply side of the credit market while ignoring the demand side. I would argue that in the current climate, the credit issue has a lot less to do with supply than demand.

I think the origins of the economic crisis lay in the globalization of labor. Corporations, over the last decade, moved production out of America to lower production costs. Simultaneously, they continued to raise prices for their products in the name of revenue growth so valued by Wall Street.

This exodus of labor has left earnings for the non wealthy on a downward trend, while prices have increased. The only way to get consumers to pay more while making less is with increased credit. Of course this bubble will ultimately burst, hence here we are.

To support this theory, I took a look at national data of tax returns from 1994 to 2006 via the IRS. The bottom 90% of taxpayer"s earnings has not exceeded inflation since around 2000.

IMHO, until earnings growth eclipses price growth, the economic crisis will linger. This will only happen when non wealthy real earnings increase or prices decrease or both. Programs such as infrastructure spending, tax cuts only for the non-wealthy, fair trade agreements (not free trade), housing relief (enhanced FHA) are some possible tools to accomplish this. America has to go back to being a production oriented economy as opposed to the consumer oriented economy it is today.

Just sayin

[truthforme]

I absolutely agree. My husband and I have been scratching our heads over this one for YEARS. The fact that growth in our economy was based on CONSUMER SPENDING (eventually, those bills are gonna catch up with you) always seemed like a house of cards to me. You cannot BUY your way into prosperity, you can only PRODUCE SOMETHING of value to the rest of the world.

just sayin

[DuganS1]

Infrastructure spending would accomplish little as infrastructure spending has very low multiplier effects and wouldn't stimulate the economy. Japan spent massive amounts on infrastructure in the 90s which resulted in little to no addition to economic growth and left them with a huge debt burden. Tax cuts for the non-wealthy is a good idea, but almost half of all workers don't pay federal income tax anyway and a lot of folks actually get back much more than they pay in because of the earned income tax credit. Blocking out some imported products sounds good to some people, until they realize it would result in increased prices, whether in imports or domestic producers with import competitions. Steel imports fell of a cliff this year and steel prices more than doubled as a result hurting companies that buy steel to manufacture their products. Housing relief it a good idea and some legislation has already been passed to in that regard, however that process takes too long to have any immediate effects. Maybe over the next year or two it will result in some more people being able to keep their houses, but it probably wouldn't help the macro issues much. About increasing our productive capacity, I completely agree, but the unions in many industries have continued to dissuade domestic companies from investing here.

[doogiedude]

As far as infrastructure spending goes, if the taxpayer is going to dole out $700 billion dollars, I feel the government should take its chances and spend this money on trickle up economics instead of giving it to Wall Street and hope they spend it altruistically. Infrastructure has been ignored for decade and is in need of repair and modernization.

As far as tax cuts for the non wealthy, I don"t know of any middle class taxpayers who get back more than they pay in taxes.

Housing relief may take a long time but hasn"t Wall Street been saying the bailout effects will take a long time?

I could not disagree more about the unions dissuading competition. Unions are organizations of employees who collectively bargain for fair wages, worker safety, and worker rights.

I think corporations are not so much dissuaded from investing here as they are attracted to places where there are no environmental protection laws, no worker rights, and no minimum standard of living for workers. Theses places are able to do this because of oppressive governments and non-third world consumption.

I suppose we could get rid of worker rights and environmental protection laws to compete with third world labor. I do not think this would be in the interests of most Americans. Rather, I think we should engage in commerce in countries only where production costs are on a more level playing field in term of worker rights, environmental protection, and minimum standard of living requirements.

[Rule Of Law]

"This all started with steep declines in home prices that decimated the value of mortgage collateral held by many banks and financial institutions."

Did it? Really? People just woke up one day and found that the value of their homes was 10 20 30 40% less than the night before? Did gnomes steal in and take value away in little wagons?

Didn't this really begin to unwind when the securitized debt--bonds, and other investment vehicles sold world wide at wildly inflated values--was found out to have been based on mortgage paper that was far less than the AAA rating it had been sold as? Isn't that when housing prices began their descent? Because a thing doesn't just lose value, unless people don't want it anymore, and the fact is that millions of Americans still want to buy homes. They Can't.

Why can't they? Because the very investment banks that sold the subprime mortgages in the first place and then sliced and diced them for world wide resale, decided to sit on their money rather than lend it out. That's when property values declined. No magic. Just bankers doing what they had always intended to do. Sell crap for a profit, and then beg for a bailout when it hit the fan.

[doogiedude]

Great post!

I think the credit rating agencies played a very dubious role in the crisis and were "partners in crime" with the financial firms.

Just sayin

[doogiedude]

A piont I forgot to mention:

IMHO, as part of "regulation reform," I would make the credit rating agencies (i.e. Moodys) government agencies.

Under the current system, Moodys rates securities of companies who have analysts who make recommendations on Moodys' stock.

This appears to be a blatant conflict of interest to me.

Just sayin

[WIpatriot]

Rule, your "gnomes" comment made me chuckle. Ever watch South Park? The Underpants Gnomes episode?? "1. Steal underpants. 2. ????? 3. PROFIT!!!" Very similar....still chuckling....

[cylindar]

Very good insight. would like to add however that the average American is such a wimp that they are not going to be able to handle this downturn very well. People think that the world owes them a living. Hahahahahaha!!!

[tcagle]

I chortle in anticipation of this myself. Too many have taken sooo much for granted, and they lack the experience to deal with this rude intrusion of reality into their lives. Priorities will change.

[BillZBubb]

Sure, the market will find an equilibrium point, but there is no telling how long that would take without major intervention. Do we want a decade long recession while this mess works itself out? I think not.

As to whether this is a liquidity or solvency problem, it is actually both. There are plenty of small businesses that need short term capital to keep functioning or to grow their businesses. They are finding it more and more difficult to get funds. They weren't insolvent, they didn't irresponsibly use debt, but they are paying the price. Liquidity must be restored to the system irrespective of whether it or the solvency of the bad lenders and borrowers is the "real" issue.

It is pretty easy to list what not to do. It's a lot tougher to know exactly what to do.

[jsarets]

Assuming we want to continue using market capitalism as our predominant means of social organization -- that is, assuming we have no faith in humanity as a social species capable of group decision-making and prefer to model our interactions purely in terms of competitive self-interest -- then the solution is clearly transparency (no pun intended).

The liquidity problem arose from the speculative discounting of debt-backed securities which could not have happened due to the decline in housing prices alone. It happened because the market can't determine the relationship between declining real estate values, increasing default rates, and the value of debt-backed securities. These investment vehicles are opaque, so when there's reason to believe they are overvalued, there's no way of knowing by how much.

Market fundamentalists believe that financial "innovations" such as securitized debt obligations and credit default swaps are examples of how markets are more efficient than other means of economic allocation. But in my view, they do nothing to change market efficiency while substantially harming the credibility and usability of markets. They introduce possible failures in setting prices, which is supposedly where markets excel.

If we have markets, then they shouldn't be so complex that you need a specialized post-graduate degree to participate as an informed actor on a level playing field. We should know what we're buying, and we should have public access to all the data we need to make value judgments. Free markets are transparent markets.

[Incredulous]

"Credit Crisis: What Should We Do?"

Stop spending money you don't have! Stop living on credit! Stop running your country on credit! Start living within your means! This doesn't take a nuclear physicist to figure out! In the short term, let the market right itself. Survival of the fittest. Isn't that what market capitalism is all about?

[Henry]

Al,
I do not know if you recall the "China Syndrome" of the sav & loans crisis, but briefly there were many "insolvent" sav & loans that were able to broker deposits (insured deposits) at very high rates to keep their entities operating...meeting interest payments, payroll etc. Problem was that each day their capital became an increasingly larger negative number (solvency heading to China). As long as they could avail themselves of FSLIC insured deposits it was business as ususal, they were swimming in liquidity. Until the govt stopped it. The funny part of this story is that you can substitite liquidity for capital, but you cannot substitute capital for liquidity.

What we are currently suffering is a liquidity as well as capital problem It is, after all, trillions of liquidity that the fed and the treasury are putting into the blood stream. The nix on the mark to market is the play that diminishes the capital solvency issue. Keep your eye on the ball, first and foremost it is liquidity.