Flying Pink Unicorns

The latest in the ongoing financial crisis.

First, serious props to my friend Ann. She's been telling anyone who would listen, for years that big financial institutions ("FI's") were overleveraged, that this would cause a lot of problems and pain in the financial system, and that these problems and pain would likely spill over into the real economy. Three Cheers for Ann! She's my financial guru, my financial Andrew if you will!

Indeed, on her website, linked to below, she has an e-mail or letter from Larry Lindsey, former economic policy assistant to President W, and a former member of the Federal Reserve Board. Of course, as a prominent Republican in money matters, he has long lied through his teeth about many things, but still, this is a hugely accomplished man. Other movers and shakers commented as well. Ann is a former Hedge Fund manager (to my understanding) and has a real insight into the deeper and darker workings of the financial system.

Oh, one other minor detail. If you read Lindsey's letter to Ann, which was quite critical of her proposed paper, it seems clear that she and not Lindsey got the best of the argument.

http://www.annsjournal.sampasite.com/


This is not real surprising to me. Ann has an enormous amount of horsepower in her brain, Lindsey not so much. Ann I hope you read this, and do be gentle with me. My knowledge in these matters is solidly intermediate, but I'm not an expert. And my blog is intentionally written so that a smart motivated person with little or no knowledge in the policy area I am discussing can really benefit from what I have to say. That my target audience.

Ok, onto the financial crisis. WOW.

Starting from the top. There are two major, related problems, which threaten to bring the US financial system to its knees, and have a slim but not zero chance of causing a collapse leading to a bad recession or worse. These problems are a credit crunch and a loss of confidence. Basically, people with money are about as scared right now as anytime since the end of WWII. They fear that the value of various securities, particularly mortgage back securities, will sharply decline, and that more banks and financial institutions will collapse, causing the collapse of others, and thus all sorts of other losses. Banks similarly have these fears of course, and are very reluctant to lend money to anyone, even other banks (usually a very safe borrower, bank failures are truly rare events in America since FDR, with a few odd exceptional periods). This causes what we call a credit crunch-- credit becomes unavailable at any reasonable price, or at times at any price at all. Quoting Paul Krugman, "This [decision not to lend money to borrowers where there is any risk] has cut off credit to many businesses, including major players in the financial industry- and that, in turn, is setting us up for more big failures and further panic. Its also depressing business spending, a bad thing as signs gather that the economic slump is deepening."

http://www.nytimes.com/2008/09/19/opinion/19krugman.html?hp

Rather than simply react to events, Bernanke and Treasury Secretary Paulson have decided to get ahead of the curve. Thus the HUGE HUGE "bailout" you've heard about since yesterday. This HUGE "bailout," costing potentially several hundred BILLION dollars, or even more (though I doubt that) isn't a bailout per se. The government is not simply lending money to banks/FIs. Instead, what will happen (assuming what we've heard about becomes law, it needs congressional and presidential approval because it is so vast in size), is that the government will buy securities which are valued based on mortgages, including subprime mortgages (mortgage backed securities) from banks/FIs. A lot of banks and other financial institutions still own these securities. It is in no small part losses in these instruments which caused the gigantic losses you have heard about in various FIs.

The government will be buying securities which almost certainly are worth something (perhaps in the end well more than the government will pay for them, more on that later). However, no one really knows what they are worth if you hold them for a bunch of years and let the housing and economic corrections play out. I note that we do know what they're worth in the marketplace today; not much. In order to get a good handle on what these securities are worth, you really have to make estimates on (a) when housing prices stop falling/start rising again; and (b) the length and depth of the economic downturn. These things are crucial because the actual value of these mortgage backed securities depend on how many homeowners eventually default on the mortgages on which these securities are based. And this, naturally, depends on how much further housing prices fall, and how bad the economy gets and how long it is bad.

Do you know the answer to these questions? I sure don't. Not a clue. My hero Ben Bernanke doesn't. My new second hero, Hank Paulson, doesn't. Ann doesn't (I'm speaking for her). No one does. Any guess could be not merely wrong, but really badly wrong.

So with all of these unknowns, NO ONE wants to buy these securities. There is very low demand for them. So the prices on the few sales that have taken place have been fire-sale prices (assuming that housing doesn't fall 30-50% from here, in which case these securities really are just about worthless in many cases).

Until there is some visibility regarding when housing prices stop falling and how bad the downturn/recession will be and how long the downturn will last, why on earth would you BUY securities based upon loans to Americans to buy houses, particularly subprime loans?

You wouldn't. But so what? Why does it matter that banks and other FIs have these toxic securities sitting on their books?

Two reasons; accounting and reality. Under US accounting rules, known as mark-to-market, banks/FIs have two lousy choices: (a) sell them, at fire sale prices, or (b) hang onto them, and recognize, and continue to recognize going forward, the big losses the banks/FIs have taken on these securities, which they bought when prices were very much higher.

The accounting matters because with these losses on their books the banks are both less willing and less legally able to lend money. Even other FIs, which aren't as regulated, are more reluctant to lend, as they just don't have as much money lying around as they would like.

The reality, that banks/FIs are out lots of money because they bought these bonds say at $100, and could only sell them now for $20 (I'm making the numbers up). That's $80 the bank doesn't have to lend that it had when it bought the securities -- the bank loaned that money out when the bought the security and can't now get "repaid" (because they can't sell the bonds for anywhere near what they paid for them.


So for these two reasons, banks/FIs are really really hurting, and unable/unwilling to do much lending. This is a key cause of the credit crunch you have heard about. It is the credit crunch that is one of the two devastating problems in our financial system right now (with a loss of confidence in general being the other). If banks don't lend, people can't get mortgages or cars, and business can't get credit to expand, or even plain old working capital. This is real, real, real bad.

The idea behind this massive "bailout" is that if banks/FI's get rid of the especially toxic securities, they will be able to go back to the markets and raise capital (the markets will be far less worried that the bank/FI will fail) and the banks/FI's can go about their normal businesses, with banks lending money again.


This sounds like a hugely good idea to me, and I am in full support of it. As I often say, I tend to the critical/skeptical when it comes to government actions. To say the least. But this sounds like just the right move, in a massive enough size to easily matter, at arguably the right time. Maybe its even later than it might have been. But this move makes all kinds of sense to me, and might well work.

As for the purchase of these toxic securities by the government, a possibly analogous model, as you may have heard, is the Resolution Trust Co. (RTC) which bought and sold a lot of real estate from failed Savings and Loans (remember the S&L crisis of the 80s/very early 90s)? Back then, the government took over failed S&Ls, thus becoming the proud owner of their assets, typically real estate. The RTC then sold off the assets, reaping what it could in the sales. Similarly, the idea here is that the government can buy these toxic mortgage backed securities and can afford to wait until market conditions dramatically improve before selling them. The United States government is so big that it can afford to have several hundred billion dollars tied up in toxic assets if need be. Then, when (I hope its not if) market conditions improve, the government can slowly but surely sell these securities, for at least as much as it paid for them if not more in many cases.

In theory the government could make a handsome profit out of this "bailout." Don't laugh, we made a nice profit from the Chrysler and Mexico bailouts, both of which were liquidity driven problems rather than a failed business model (like GM today or Enron of 2001). Both needed a ton of money, yesterday. Both Mexico and Chrysler got big money from Uncle Sam, both paid their loans off early, with interest.

This "bailout" is much, much trickier, but still, a profit isn't wildly unlikely, and a situation where the government gets back say 70% of what it lays out is, in my somewhat ill-informed opinion, reasonably likely, as these securities have already come way way down in price. The government would be buying cheap. Yes it would be buying trash cheap, but still cheap. In addition, this big action, together with other actions, increases the chance that the recession I believe we are in will not last more than 6 more months.

There are other aspects to this "bailout" including the fact that merely by entering the market for these toxic mortgage backed securities the government will probably put a floor under the price that these securities are trading at, at least for the time being. But the principal effects were as I've described above.

Questions? I plan a follow up post. I also plan a post where I discuss the failure of Lehman Brothers and comment briefly on the bailout of Fannie Mae and Freddie Mac.