We Must Face the Music with Banks
The source of our economic crisis is the decline in home prices. Most of everything else happening right now, including the trouble of the banking system, are symptoms of that fundamental problem. Therefore the solution to our financial crisis, and the cure to the banking system, will only come when home prices stabilize at a new economic equilibrium.
Since 2001, we had excessive money growth (over 8% annually). The Fed funds rate that began 2001 at 6.25% ended that year at 1.75% and reached a record low of 1% in 2003. Low interest rates spurred buying, and because the supply of housing is relatively inflexible, the buying pushed up prices and created a real estate bubble.
The increase in real estate prices made people feel richer and triggered increased consumer spending. Many believed they didn't have to save as much and could borrow more against their increased home equity. Abetted by corrupt and greedy lenders, Americans used unprecedented debt levels to buy more goods, especially real estate, thereby reinforcing rising prices. Average U.S. household debt reached a record 141% of disposable income.
The resulting levels of consumption and even business investment were unsustainable. The new real estate wealth was a fantasy. The economy's ability to produce real goods and services is determined by the amount of available equipment, the number of workers, the supply of raw materials, etc., and those haven't changed by much. So the bubble burst, as bubbles do, exposing the huge debt used to buy real-estate backed assets, and triggering a massive loss of wealth.
According to real estate data service Zillow.com, the U.S. housing market lost $3.3 trillion in value last year and $1.4 trillion in the fourth quarter alone. Nearly one in six homeowners with mortgages owe more on their home loans than the homes are worth. Home prices have fallen for eight straight quarters. New foreclosures add to inventory and depress prices further.
Clearly, the worst hit are the banks, and the magnitude of losses suffered by the financial system is staggering. Many banks carried assets 40 times the size of their equity, which means that a 2.5% loss on their assets would completely wipe out their net worth. The average U.S. investment bank was leveraged 25 to 1 at the end of 2008. In Europe, average leverage was more than 30 to 1 (in Britain, bank balance sheets are equal to over 400% of gross domestic product). The combined balance sheets of the three largest U.S. banks, JP Morgan, Citigroup and Bank of America (over $6.5 trillion) add up to nearly half of the U.S. GDP. Add to that the combined exposures of mortgage lenders Fannie Mae and Freddie Mac and almost the entire U.S. GDP is tied up in just those five companies.
All these over-priced real estate assets coupled with leverage created losses, and those losses, the fundamental problem we are facing, have to be recognized. We can't run away from them, sweep them under the carpet in Washington or try to postpone the inevitable.
More importantly, a crisis of excess debt cannot be solved by more debt, even if that is exactly what the Obama administration is proposing. The stimulus package of over $800 billion (most of it social spending and not stimulus), is 6% of GDP on top of a deficit already projected at $1.2 trillion. We simply cannot spend our way to prosperity.
Japan spent a decade and trillions of dollars paving rural areas with roads, dams and other infrastructure projects, trying to lift the economy from a severe downturn caused by the bursting of its real estate bubble in the late 1980's. In the process, Japan ran up debt totaling 180% of its GDP, and got no recovery. All that spending did little more than sink Japan deeply into debt, leaving an enormous tax burden for future generations.
That should have been obvious. If the government borrows money for the stimulus, it will either have to print money or raise taxes in order to pay it back. Raising taxes is in effect robbing Peter to pay Paul, and printing money means devaluing the currency and that is tantamount to robbing Paul to pay Paul back with inflated currency. That does not address the problem we are facing and is just a way to treat the symptoms and defer the real solution. Moreover, the resources taken away by the money borrowed by the government, money that won't be available for private investment, have a substantial adverse impact. Nobody in government can spend other people's money better then they spend their own.
It is also useless to create a "Bad Bank," because its purpose is to shift that loss of wealth from the shareholders of the failing banks and distribute it to all taxpayers. That is not smart, nor is it fair. Unfortunately, we already have a "Bad Bank." It is called the Federal Reserve, and it was buying so many abstruse assets from commercial banks that its balance sheet has more than doubled, from $900 billion to more than $2 trillion, since September. No other time in U.S. history has seen a monetary policy remotely as expansionary as what we have now.
Instead of recapitalizing and subsidizing the foolish and irresponsible banks that got us into this mess, and instead of funding their excessive bonuses, we should let home prices fall to their economic equilibrium. It will force people to be realistic with their spending and return expenditures to sustainable levels. We all must adjust to the new reality. Capitalism is an evolutionary process and adjustments are part of it. This is agonizing but nonetheless necessary if we are to have real economic growth.
In the end, the business cycle is mostly a monetary phenomenon impacted by credit and money supply. Sound money lets the invisible hand of all the different participants in the economy express their will and their knowledge through the price mechanism and rationally allocate capital, not by government bureaucrats but by entrepreneurs who must satisfy consumers or go out of business. If we continue on the path we are on, ignoring economic realities and trying to artificially prop up our banking system, we are going to learn an expensive lesson.
Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at aschram@wellcappartners.com.
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In my view, http://www.huffingtonpost.com/henryk-a-kowalczyk/its-time-for-financial-di_b_128466.html , we got in hot water as in our system bankers were able to collect hefty commissions on moving around inflated (toxic) assets.
The most what the government can do is buying some time, so bankers can figure it out between themselves what they are worth. The simplest way of buying time is by issuing at hoc emergency loans to individuals who cannot afford paying their mortgage. If by issuing these loans, the government would guarantee that no one house would be foreclosed within the next six months, but six months only, then within this time banks would figure it out the real value of their assets. Just to be clear, if an individual receiving a loan to cover mortgage for the next six months would fail in paying mortgage afterward, bank would repay government first before getting any money from the foreclosure.
It means no dime for Wall Street bailouts.
$4 per gallon gas was the pin they used to pop the housing bubble. printing more money doesn't become inflationary until you print more than the wealth that has evaporated from the markets, home values, 401(k)s, etc. we won't truly get back on track until we start paying off the republican debt, which means putting people to work so the government has a tax revenue stream to use to pay down that debt.
I think my Grandfather said it best, he's been around a while and it's in times like these where the resonance of experience and wisdom rings loudest and most true. It's not a sentiment I'm eager to embrace as it breeds tremendous resentment in me for both my parents and his generation. His mantra is basically this; "we must accept a lower standard of living, simply put, we've been living beyond our means for many years and unless we come to accept this truth and adjust our standard of living accordingly we will continue to see global economic decline." I'm just glad I got to ride on his coattails for the last 27 years and experience a standard of living I won't see for many, many years. I'll miss it dearly.
It's very interesting to read attempts such as this one to explain the causes of the current financial situation. Your attempt, Mr. Schram, is one of the more informative I've read. It is written from the standpoint of a believer in capitalism, and tries to line up the circumstances to defend and perpetuate that worldview, arguing that certain abusers of the system encouraged people to spend unwisely, precipitating a financial avalanche--but the system is not to blame. I believe that the capitalist system inherently approves of ruthless greed and materialism--the definition of a successful person is one who is able to assemble the most financial assets. How can someone who is raised to evaluate their human worth in this way possibly curb their appetite to acquire more than their neighbors? What is needed, in my opinion, is a massive public dialogue seeking to redefine the goals of our civilization to achieve something more profound and life-giving than "economic growth".
There are a lot of people and firms and funds who have made a lot of money yet produced nothing. It is true that if there is someone who takes something without "earning" it, then there is someone who has "earned" it yet gets nothing. Financing the creation of new money for speculation gains should be as popular as pro athletes performance on steroids. We live in a culture that adores without any sort of ethics meter. Take Madoff.
Well said, Henry.
I really don't think that banks should take advice from hedge fund managers. Hedge funds have been some of the primary profiteers off of the falling stocks of banks, and in many cases have manipulated those stocks to lose value. Pardon my French, but go stuff it.
So our problem is so simple, eh? How about these factors:
excess liquidity leading to housing bubble
credit default swaps unregulated, traded around the worldm, falsely labelled AAA investments
impossible to pick up the endless pieces of the split derivative bundles of defaulting mortgages
ballooning executive pay and compensation draining financial integrity from big corporations
financial fraud rampant, no effective policing by SEC
lack of adequate reserves at insurance companies and lenders
lack of chinese wall between commercial banks and brokerage houses
excess consumer debt leading to defaults on credit cards and car loans
exportation of good jobs
lack of adequate corporate taxation to support re-building infrastructure
burden of government taxation falling disproportionately on middle class
federal deficit spending on military misadventures
increasing obligations to wounded military veterans and their families
declining affordability of fossil fuels
increasing hostility of countries controlling fuel reserves
eroding american infrastructure, including electric grid, water pipes, mass transit
declining middle class standard of living and increased personal debt
increased global warming leading to worsening of crop failures, desertification
spiraling competition for natural resources, including water, oil and enriched uranium
nuclear proliferation and impending militarization of space
You are mixing a lot of apples and oranges. We have a real banking crisis (apples) and we have a structural crisis that was 30 years in the making (oranges). Carter got it right and Reagan and everyone else since then had it wrong. The solutions for one are not the same as the solutions for the other. Neither are the timescales. It will take the US 30 years to rebuild infrastructure, solve our energy dependence problem and re-educate a generation of people about personal finance, the need to get an education and strive for higher paying jobs etc.. The fix for the financial system are more regulation and monetary props until we can sleep sound at night that these institutions don't self-combust. That will take about 1-2 years. But that's just the first step of a decade long journey to make the US into what it needs to be from where it is right now.
Don't get me wrong, James Earl Carter is my favorite of presidents, but he was at the crest of deregulation. This got rid of usury and let rates seek their market levels. You may think this was the Reagan mantra, but the Carter era thought was with it. In this sense it is similar to Clinton and NAFTA. I do follow your thinking (I think) that the current mindset is such that markets are so prescient that they (the markets) can properly price risk. So securitize the volume of similar types and have the invisible hand of the market set a market price to compensate for the risk. ( little George actually believes this still) But Jimmy was on the front end of all of this.
Sanity could grow on us. The impetus to the equilibrium that we so desparately need is a positive real interest rate of 5% or so for Prime and 2% or so for saving. This would put Prime at about 8% and savings at about 5%. The watch the values of homes adjust via the market mechanism that can be sustained. We got into the mess from negative real interst rates, Ben has us still on negative real interest rates. There is no real incentive to save and as a result banks have no irrigation for their lending fields. This would put home rates a 7% fixed or so. It's the cure. Cold turkey.
The left thinks we should "nationalize" the banks. The right thinks we should "let them fail". Are these indeed two opposing viewpoints, or are they two rhetorical devices that actually mean the same thing?
When businesses become insolvent, they are either acquired by another business or seized by banks for restructuring or liquidation. When banks becomes insolvent, they are either acquired by another bank or seized by the government for restructuring or liquidation.
How can a bank enter bankruptcy proceedings without being put into public receivership? When Lehman was "allowed to fail", who do you think took ownership while the assets were liquidated? Nationalization is where banks go to die -- or be reincarnated.
The left and right seem to be roughly on the same page. The center is the common enemy. They don't want the insolvent banks to be liquidated or restructured. They just want to prop them up forever and pretend that they aren't already bankrupt.
The center doesn't want to nationalize them and be perceived as hostile to investors and lenders or let them fail and be perceived as hostile to workers and business. They don't understand that it's the same thing, and everybody will have to take a haircut. And even if they did, they would want to postpone the suffering for as long as possible, even if it makes things worse.
The "center" is half way across the chasm.
Falling fast.
This post is naive.
Home prices aren't going to fall to a new economic equilibrium until the economy can support said equilibrium.
The problem has evolved way beyond the housing bubble. It's not the kind of catastrophe you can simply reverse.
Home prices where I live have not been falling that much. Total turnover has gone down as less people are trying to make a quick buck by flipping and owners are more reluctant to sell their home "at a loss" (even if it was never worth as much as they want for it) and move away. Home prices are still far above historic averages and it would take at least another 25% correction to get even close to affordable homes prices that can be sustained at long term interest rates of 6-8% (higher would be better or we end up with a rinse and repeat).
There are other places, of course, where developers overbuilt and there are just not that many people to buy their copycat McMansions as home bases for 40-60 mile (one way) commutes.
I don't think this was about reversing the situation, either. The new equilibrium will not be the same in all regards as the old one. For all we know a lot of jobs in the automobile industry will be gone. We have to replace those with new jobs, e.g. in the field of conservation and renewable energy. Look at the Great Depression. The people who left their desolate farms didn't move back, either. They found new jobs elsewhere. If they were lucky, that is.
I think it's selve serving. not Naive. deceit.
I think it's self serving. not Naive. deceit.
Shorting real estate?
The problem is the lenders did not get PMI.
The bigger problems is that deregulation allowed you hedge fund folks
to create a 600 T$ derivatives market.
CDS: folks betting on stock of the weather, ot index rates.
Pure off track betting.
Japan tried to bailout the banks: THAT"S WHAT CAUSED THEIR LONG DEPRESSION!
I think there are number of differences with the Japanese experience that need to be noted. First, Japan was slower to react to its crisis than we have been. Second, Japan spent huge on stimulus but it also raised taxes which diminished the effect of that stimulus. We aren't going to raise taxes, if at all, until 2010. Third, the Japanese have a ridiculously high savings rate. This is typically a very good thing but it becomes a huge obstacle when you are stuck in a liquidity trap. No doubt Americans need a positive savings rate in the long term, but in the short term we need consumer spending to rebound so we can avoid a vicious deflationary or non-growth cycle that hobbled Japan for a decade. Luckily, Americans will have no problem spending money generated by the stimulus (ensuring that velocity and multipliers have their intended effect). Fourth, the world is running to T-Bills as a refuge which, kinda of perversely, allows the country most responsible for the global financial meltdown finance its stimulus at very low borrowing rates. Even with all of those advantages, however, we may be on track to creating the same zombie banks Japan did in the 90s. Our Treasury Secretary seems to be favoring policies that would permit the troubled companies to continue to hide the scope of their losses so that shareholders and bondholder recoup on bad investments and we can pretend that we didn't actually nationalize corrupt, failed banks.
This is basically a do nothing prescription and really will lead to a second Great Depression. This is VERY stupid advice. We certainly can spend our way out. Japan is not a good example as they did not really need infrastructure, they have a shrinking population, lots of differences.
Afterwards, I think most economists should be focused on how to prevent bubbles---if it is even possible. And, the US should rethink globilization, which has lead to a country that doesn't make much of anything.
With all the offshore shell games banks such as Citigroup and JP Morgan played with the likes of Enron and no telling what sort of money launderers it's getting kind of tired blaming the global crises on ONLY mortgages.
It's all catching up - the Ponzi schemes and shell games.
Today it was reported there was laughter at the Treas. Sec. plan.
That's because the elephant in the room isn't the GOP it's the idea that the government actually thinks the banks will be willing, transparent partners in anything to help the citizens. Open those books to the government? Doubt it.
Wow, Mr. Schram... while I usually don't buy into your writing, with this one you hit a home run.
:-)
I agree that the banks must be allowed to fail. After all, isn't that the cornerstone of a truly free market? But statements like this--
"It will force people to be realistic with their spending and return expenditures to sustainable levels."
to me tip your hand about what you see as the problem here, and it begins to sound as though you are just another of those who want to blame the consumer, the home buyer, the average middle class worker, not only for the problems they find themselves in, but for the entire country as well. Now I could post, yet again, Bush's speech from 2003 where he tells the country to go out and buy homes, and Greenspan's quote about how there is no housing bubble from the same year. I can show you how the FED rate was manipulated to allow cheap money to flow into an artificially constructed housing bubble in order to hide the recession that the Republicans never got us out of. I can show you that this was policy right from the top down and now the people you expect to pay for it are the very ones most damaged by it? Sorry. I don't agree.
Rule, there is no such thing as a "middle class worker". Workers are, by definition, "working class". They depend on the economy way more than middle class people and they do feel the brunt of what is happening all the time without ever getting to profit from the upside. The US "middle class worker" is a political lie that the country has swallowed hook, line and sinker. Working class home ownership, which is being taken seriously by other countries, is usually handled by dedicated savings and loan agencies which have extremely low risk profiles. The worker can not just walk in there and get a home loan at the terms of the day. Instead they have to build capital first and are then assigned a loan which is set by the terms of the savings and loan and not some intermediary loan shark. These loans are usually not enough these days to buy a single family home, although they used to be in the past, which is why cities allocate a certain number of low cost apartments for working class people. People above certain income limits do not qualify for these loans and have to borrow in the free market. So the lower middle class is really the ones which is priced out of both the low and the high end markets in countries which use this "socialist" approach to housing.
We agree, mostly. An electrician or plumber making low to mid 6 figures a year is still considered "working class" but his income is high middle to low professional/white collar. You are right about how impacted blue collar workers are though. And it's good to hear that other countries take home ownership seriously for all classes--my guess is that those countries probably also educate their workers from grade school on the importance of saving and budgeting; things the education and political systems avoid here in the states as though it might poison us. As for socialism, as you and I both know, it's just a word to evoke knee jerk passions among the ignorant. Social Democracies, if our leaders were really leading and not getting their orders from Wall Street, would be the rule rather than the exception. Keep talking and I might emigrate to one of those European workers paradises :))
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