The massive wealth destruction the world is experiencing stems from the decline in asset prices, chief of which is housing. Housing prices have to fall because they have been inflated for years, but they will ultimately reach an economic equilibrium and cease going down. When that is accomplished, the financial system will recover and the economy will also improve, which in turn will boost business investment, corporate profits and employment.
But until that happens, our banking system is rapidly collapsing before our very eyes, and the Obama administration is feverishly trying to save it and considering different plans to do so. Professor Jeffrey Sachs proposed in the Huffington Post a "contingent warrant" plan, where the amount of equity transferred to the taxpayers would be determined only after the government has sold off the toxic assets. I believe such a plan creates another devastating layer of uncertainty. It would take time, probably years, before we know the realized value of those assets. We do not have the time to figure out these eventual values. You cannot attract private capital under such circumstances, and without private capital this plan, any plan, is doomed.
The problem is not that banks are not lending, as some people in Congress and the Media have been complaining. In fact, according to Federal Reserve data, bank lending has grown 5.7% since the recession began in December 2007, and consumer loans grew 8.9% (although home equity loans actually declined). Banks have recently tightened their lending standards, as is prudent, but fresh capital courtesy of Congress has made it possible to make new loans. Banks are in the business of lending and do not need encouragement, let alone coercion, to sell their product, any more than a grocery store needs incentive to sell milk or bread.
Rather, the issue is that with yields on investment grade debt higher than the economy's growth rate, it is not financially viable to lend. The cost of new debt is higher than what businesses can earn. That is why businesses are delevering and banks are reluctant to lend. In addition, investment funds and Wall Street firms have been forced to downsize, and by doing so they continue to drag down prices of real estate, municipal bonds, credit card receivables etc., and generally exacerbate the implosion of credit markets.
Seeing this, private capital is fleeing, even from the strongest banks: Wells Fargo is down nearly 60% so far this year; US Bancorp is down almost as much (not unreasonably: marking the banks' assets to today's market would leave most banks insolvent). This indicates the market is losing confidence in the Obama team's ability to fix the crisis. Private investors are worried the policies of the Obama administration are not effective and perhaps worse, counterproductive. There's been barely a positive day in the Dow since Treasury Secretary Geithner unveiled his plan.
It is clear that without a cure for the banking system, the credit crisis will linger. To combat it, Secretary Geithner has to become more articulate and unambiguous. So far his policies have been either incoherent befuddlement, or simply outright penalizing and even retaliatory to banks' shareholders. Castigating the institutions that need government support as the culprits, which they may very well be, is not very conducive to resolving the problems at hand. Investors, already confused regarding who is in charge, will not put money in any financial institution when the government's policy is not to allow shareholders to earn significant returns in exchange for assuming the risk.
The government's experiments serve to prove the obvious fact, that none of the experts have any idea how to deal with this crisis and are simply practicing at our expense. And their actions have broad unintended consequences. In economics, every action creates a reaction, often an unexpected and undesirable one. Instead of providing calm the Obama administration provokes further fear and uncertainty, which are not welcome by the markets.
Moreover, we have other problems brewing. Recall that last year, foreign borrowers have absorbed about $200 billion of treasuries, which helped finance the $450 billion deficit we ran in 2008. The 2009 deficit is going to be more than double that, which means the Treasury department will need to raise about $1 trillion (that's 1,000 times $1 billion) next year from domestic sources, which has never been done before.
Even if US savings rate were to rise from zero to 8% of disposable personal income, which is the prevalent rate in other industrialized nations, that would create about $800 billion in additional savings available to finance the deficit, which isn't enough. Given our lax monetary policy and our vast and profligate spending, interest rates will have to rise sharply, reflecting more adequate compensation our lenders will require.
In response to all this, the U.S. government seems to be on course to nationalizing the banks, or putting them in conservatorship. That will mean suffocating free enterprise, and sounds like something Hugo Chavez does. And I am skeptical government management can really revive the banks. Mr. Geithner is a central banker, Dr. Summers an academic and President Obama a lawyer by training. All are very smart, but none of them, as far as I know, has any experience working in the private sector or running private, for-profit firms. Management by a committee of experts is bad enough; management by a committee of amateurs is truly scary.
Just imagine Washington regulators, previously in charge of Fannie Mae and Freddie Mac, deciding the appropriate size for banks, the level of compensation to attract employees or the suitable dividends. This is not only quasi-Marxist but also highly inefficient and unsustainable, particularly if you plan on raising private capital alongside government financing.
Alas, it seems we are already on that road, with no turning back possible. De Facto, we have already nationalized most banks, given that even relatively solid banks like Wells Fargo would be 35% owned by the government if all the TARP money was converted into common equity today. In the case of weaker banks like Citigroup, the government would own a majority stake.
The damage to the system is done, and all that is left for the government to do is plunge in, eliminate the weakest banks, provide plenty of capital to the surviving ones and gradually sell off the bad assets. It is not a "bailout" if bank shareholders are being eliminated, and it will at least end uncertainty, cleanse the system and enable a fresh start, which is necessary. This lugubrious episode might serve as a reminder that Thomas Jefferson was right when he commented that banks are more dangerous than standing armies.
Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at firstname.lastname@example.org.
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