Stoopid Stuff

Stoopid Economic Analysis III - Solvency, Liquidity, The Japan Example and the Swedish Solution

Big Stim is out of the barn. Smaller, and significantly less effective than it should have been, it is nonetheless the law of the land. Dollars, some actual, some imaginary, are about to begin flowing in a large-scale attempt to create jobs and thus "stimulate" consumer spending. After the madness, heartbreak, horror and disillusionment of the last 4 weeks, this may be hard to grasp, but that was the easy part.

Next up? What to do about the banks. In the final analysis, the answer to this question will be determined by the willingness, or lack thereof, of the American government to be honest with itself and the American people about the real state of the banking and credit institutions.

Put in it's simplest terms, a lending institution is supposed to have assets, money or things of value, to support the loans they make. A common rule of thumb is they should have 1 dollar of real assets for every 10 dollars of outstanding loans. And banks have always be very vocal about their assets, as a way to talk about their strength and stability. Since the Great Depression, there has been a regulatory and oversight regime in place that would ensure that banks were bona fide lenders and not just a ponzi scheme.

Along comes the "Reagan Revolution", wherein we learned the conventional wisdom that the government was incapable and incompetent, and therefore should do nothing. "The Market" was described as this perfect force for good, that would reward sound business, innovation and risk-taking. Over the decades, as this belief became unchallengeable fact, regulations were removed, oversight was dismantled and, while everyone was perfectly aware that this only left the fox guarding the hen house, all the right people were making tons of money, so, while a few voices shouted easily ignored warnings from the wilderness, the system entirely unravelled.

At that point, it was only a matter of time. The housing bubble allowed the creation of all these ridiculous derivative investments, CDOs and CDSs, primarily, that the rating agencies were essentially bribed to rate as AAA and the financial industry bought, bundled, traded, divided, sliced, rebundled and resold until you had $60 trillion in securities backed by $15 Trillion dollars in actual mortgage loans. All completely and specifically outside the oversight of ANY regulatory body.

Which brings us to now. Some very large but as yet unknown percentage of the banks stated assets are represented by these types of securities. The banks know two things. First, they DO know what they actually paid for them. Second, they know that at this point they can't GIVE them away. If these securities are merely worth less today than they were when the banks bought them due to the bursting of the mortgage bubble and the recession, that is, if they still have inherent value, the banks are merely illiquid and require only additional capital to make it through to a future time when the inevitable upswing in the business cycle re-inflates their value. At that time the banks could pay off their bridge loans and go back to being profitable businesses again. Unfortunately, almost no one, at this point, believes that to be true.

Instead, it is likely that these securities are nothing more than fraudulent pieces of paper, worthless now and forever. Which, depending upon how much of their stated assets were represented by these artificially - valued securities, would make some number of America's larges banks insolvent. We have a mechanism for dealing with insolvent banks. The government seizes them, recapitalizes them, cleans them up and runs them until they can be re-privatized. The new owners pay off the government and thus the taxpayer is made hole. This is what they mean when the talk about the "Swedish Option". Sweden was forced to nationalize it's banks in 1992, and it all worked out quite well. You can look it up.

On the other hand, there is Japan. When growth slowed in the '90s, Japan's banks found themselves with grossly overvalued assets. Government's unwillingness to aggressively address the problem lead to nearly a decade of deflation and stagnation, with businesses unable to acquire the credit for investment and banks unwilling to take on any risk that might expose them as insolvent.

Of course, this is America, and in spite of the lessons of economics and history we must fear anything that the most dishonest right-wing politician or pundit might rail against as "Socialism". We're not sure why, most Americans don't even know what Socialism is, but they're certain it's a bad thing to be avoided no matter what the benefits of nationalization might actually be.

So here's the next big event. Watch the Obama administration closely. They got burned by the republicans on the Stimulus plan. They are much more likely to take more of a "My way or the highway" approach to the bank bailout. But therein lies the key question: What will represent "Their Way"? Will it be Sweden or Japan? There is speculation that by adopting a marginally incoherent "go slow" approach, where the Treasury "stress tests" the banks, ostensibly to determine how much of their assets are overvalued, the administration will actually force the banking industry to determine the actual market value of the Mortgage Backed Securities now being referred to as "Toxic Assets" and therefore will be forced to admit they are insolvent. At that point there is no real option but to take them into receivership. This plan, of course, fails to take into account the survival instincts of the banking executives. They are, it must be accepted, less concerned with the viability of the American Economy than you and I, and as such must be recognized as an obstacle to a good outcome, and not a partner.

History has shown clearly that now is the time for aggressive, decisive action on the part of the government. So far, they've appeared timid and uncertain, which does not bode well for our financial future. But at this point all we can do is email our congresscritter and the White House, then get a big bowl of popcorn and watch the fireworks. The collapse of the largest economy on earth should at least provide some entertainment value....

posted by mikey @ 10:19 AM