THE BLOG
03/12/2009 05:12 am ET | Updated May 25, 2011

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.