Fix the Credit Problem, Not its Symptoms

Two weeks ago Monday, markets traded down 300 points at the open. The sell-off seemed to be in anticipation of what was widely considered to be a poorly thought-out bailout plan. As it became clear that the $700 billion package was not going to be approved by the House, the Dow Jones Industrial Average plummeted another 500 points. Stock jockeys had apparently decided that a bad bailout would have been better than none.

Fast-forward to the end of last week: During Friday’s House vote, the Dow rallied 300 points . . . but once the bill passed, they promptly reversed and sold off. It’s been more or less straight down ever since. Since the highs of October 2007 one year ago, the Dow has lost 39%, or about 5,500 points.

How did this happen? Why are markets reacting so negatively to a near $1 trillion bailout? The short answer is that the Federal Reserve and the Treasury Department have been focusing on the wrong issues. They have been treating falling asset prices—houses, stocks, bonds—as well as the lack of confidence between banks, as the actual issue. This is the wrong approach. Falling asset prices and a lack of confidence are a result of the underlying problem. You don’t cure alcoholism by getting rid of a hangover; you cannot resolve confidence issues by merely cutting rates.

The primary problem is that banks are refusing to extend credit to each other. Why? Because they do not understand the liabilities of their counterparties. Translated into English, that means they don’t know if the other bank whom they are dealing with will still to be standing tomorrow.

The thing roiling markets today is not the lack of confidence; It is capital, or more accurately, the lack thereof. Thanks to a series of very poor trades—excessively leveraged and absurdly risky to boot—banks are now dramatically undercapitalized.

As we have seen in just about every historical financial crisis, the shortage of capital is the underlying cause of monetary mayhem. Too much debt, too little equity, makes any financial system cease to function.

Why is that? Consider the way fractional banking works. Depositors open accounts with banks, earning interest, along with ready access to their accounts at any branch or ATM. The bank leaves a small fraction of the money on deposit, and uses the rest for loans, either to businesses or consumers. The smaller the fraction retained on deposit by the banks, the more money they have to lend out, and in theory, the greater their potential profits.

This is a quaint, 18th-century system. It worked well—at least before the modern era of derivatives and excess leverage. In ye olden days, a bank would get a $10 deposit, keep a buck as reserve cash, and lend out the other nine. Assuming they were careful about who they made loans to, this was a profitable enterprise.

In recent years, banks ran into three kinds of trouble: They made loans to people who failed to repay them; they did not keep adequate capital on reserve; they compounded their problems by borrowing money from each other to buy back all of those loans after they had been repackaged as fancy securities.

If it sounds ridiculous, it is only because it was.

What makes the current crisis so dangerous is that all these complex financial maneuvers have left the institutions themselves shell shocked. They no longer know who to trust. When Banks cannot tell if the other bank across the street has enough money to survive through tomorrow, they cease credit operations. As long as this condition exists, banks will be reluctant to lend money to anyone but the strongest financial institutions, who of course, do not need it.

Hence, a credit freeze.

Under these circumstances, the original Paulson rescue plan is unlikely to accomplish much. Buying up risky assets from the banks, which is what Troubled Asset Relief Program (TARP) is set to do, is like slapping a coat of paint on a house infested with termites. It may pretty up the banks for a short period of time, but it is unlikely to solve the underlying problem.

So what would solve it? The first step to accomplish this is triage. Identify the banks that cannot survive, and like Old Yeller, gently put them down. Euthanize the bad ones so the good ones can survive. Nationalize ’em, sell their accounts to strong banks, and prevent further liabilities to the FDIC (which insures all accounts up to $250,000).

Next, recapitalize the banks that can survive by buying preferred stock. That is what Warren Buffett did with General Electric and Goldman Sachs when he made his investments. The Treasury should announce a matching program, where any private investment into a Bank is matched by the government, dollar for dollar, and on the same terms. This fixes not merely a balance sheet issue (like TARP does) but the actual capital structure at the root of the current crisis. And it does so on terms that are good for the taxpayers too.

As this process eliminates the bad banks and recapitalizes the good banks, normal lending will resume. Defaults and insolvency will no longer paralyze the financial industry. This is how Sweden resolved its financial crisis in the nineties, and how England just started to address their problem this past week.

The good news is that the US is that there are signs the US is starting to move towards the Swedish / British / Buffett model. The bad news is that it has taken this long to even begin contemplating this.

We are a year late, a few trillion dollars short. And, its too late for firms that could have been saved had there been clear eyed leadership in Washington, instead of mindless cheerleading. As recently as a few months ago, we were being told thast the economy was sound, the problem was contained, the dangers minimal. Instead, a parade of firms such as Bear Stearns and Lehman Brothers and AIG and Fannie Mae and Washington Mutual and Freddie Mac and Wachovia and Merrill Lynch are now lost. That is going to have lasting repercussions for the national economy, and it is going to be felt especially hard in places like New York City, Connecticut and California.

It might be glib to say “Better late than never.” But that fails to capture the lasting economic damage caused by missing this opportunity for so long.

To give you an idea of how costly this delay has been, consider the S&P 500 financial sector index. It is comprised of over 80 of the biggest banks, brokers and insurers in the United States. At its peak in February 2007, it was worth almost $3 trillion dollars. Since then, it has since declined 56.5%, losing over $1.7 trillion dollars in value. And that is just one index, and not the entire US financial sector.

When banks know their counterparties are not in danger of going belly up tomorrow, they will begin lending again. Confidence will return once the underlying problem is resolved, and not a minute before.

Originally published at The Big Picture on Oct 10, 2008 and reproduced here with the author’s permission.