Credit Crisis: What Should We Do?

11/06/2008 05:12 am ET | Updated May 25, 2011

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.