21 March 2009

Bailouts are Wrong-Headed by Gordon Ringoen March 20, 2009

I recently saw the Harvard Law professor, now in charge of Trouble Asset Relief Program (TARP) oversight, complain that banks were not actively leveraging and lending the TARP funds provided by the government. She said that the banks should be hit over the head to get them to lend so that the economy can recover.

She was undoubtedly parroting the thoughts of Treasury Secretary Tim Geithner and would undoubtedly be supported by Federal Reserve Chairman Ben Bernanke.

Unfortunately, their economic theories are just plain wrong. They do not apply to the real financial world.

Let me explain.

Conventional economic theory
Fundamental to nearly all economic theory is that supply and demand can be charted by a simple diagram. In the case of credit, the vertical scale is interest rates. The horizontal scale is the amount of money loaned. The demand for money is a diagonal line going from high to low from left to right. The supply side is the opposite; from low to high from left to right. Where the two lines intersect, is where loans take place. The left scale tells you the interest rate and the horizontal scale tell you how much will be loaned. The chart indicates that there is more money to be loaned as the interest rate rise, while demand goes down with higher interest rates. Conversely, as interest rates decline, less money is available to loan but the demand rises. Where these supply demand lines fall is determined by the inflation expectations of lender and borrower. The higher the inflation rate, the higher the interest rate. The intersecting point of supply and demand is perfect equilibrium! How nice! You certainly remember this from your basic economic course. This theory is a fundamental principle to Bernanke’s economic textbook titled “MACROECONOMICS” which is used by more than 200 college professors. You can add more than another 100 with N. Gregory Mankiw, Harvard professor, and the former chief economic advisor to President George W. Bush, in his textbook, “PRINCIPLES OF ECONOMICS.”

This theory makes the following assumptions:

+ The market for loanable funds is perfectly competitive.

+ The interest rate is determined by the bargain between lender and borrower.

+ It assumes that borrowers really consider inflation expectations in their decisions.

+ There is sufficient supply of loanable funds and sufficient demand from borrowers to actually make a market.

+ That the lenders and borrowers are rationale.

+ Debt is merely the transfer of savings to a borrower.

Therefore, if you accept this theory, there is insufficient money being loaned, there must be a weakness in one of the assumptions. No one is claiming the market has lost its competitiveness. There could be a different view between lender and borrower regarding inflation expectations or interest rates, but that is belied by the market for Treasurys, which currently enjoy very low rates across the yield curve and inflation-adjusted Treasurys sell at only a modest premium to Treasurys. There obviously is no shortage of demand for loanable funds. There are cries of credit anguish from credit card borrowers, mortgage and commercial borrowers. Voila! The problem must be a shortage of loanable funds! It is a liquidity problem! Therefore, if we shovel money into the banks, we will be on the road to recovery. Or, as we prefer to say, bailout the banks and they will loan.

The only problem is the banks aren’t following the theory by lending. Thus, we have the suggestion that they need be hit on the head.

Reality bashes economic theory
The real problem is that the supply/ demand theory is just about totally wrong. This same theory that did not allow the experts to foresee the financial bubble developing is not going to show us the way out of our dilemma.

Let’s look at why this theory is hokum. The following thoughts are not based on theory, but on practical experience and observation of how the financial markets actually work. I don’t think that many who actively engaged in finance would disagree.

+ The financial market is not perfectly competitive. It tries not to be competitive at all. Every market player tries to distance himself from the competition. Competition is anathema. In industries where there are many buyers and sellers of essentially identical products like corn, sugar, and oil, the government steps in to provide price supports, fixes prices or allows formation of cartels to protect the suppliers. Even in the financial industry where the final commodity, money, is all the same, every lender tries to differentiate their loans by industry, location, convenience, size, industry expertise, term, covenants, interest rates, or trips to Las Vegas.

+ Interest rates are not set by bargain between the lender and borrower. Interest rates are set by the lender. Even in debt auctions, the lender determines the interest rate he will accept. Borrowers may be able to negotiate terms and conditions but not interest rates. A borrower can shop between lenders for a lower rate, but only rarely can he get the lender to lower his rate.

+ Commercial lenders don’t give a hoot about inflation; they only care if they get their spread over their cost of funds and that they will be repaid.

Now comes the hardest part to accept. Demand for credit is infinite. Supply of credit is finite. The process of credit might be likened to conception, although it might look to an observer, such as an economist, that there is “equilibrium” in conception of one sperm and one egg, it tells nothing about the process of conception. The reality is that there are 5 billion sperm all competing for the egg, but only one succeeds. So it is with credit demands. If there is money available, there are infinite takers. I had a levered business associate, now deceased, who would have single-handedly borrowed all of the money in the world if he could have. He had no compunction about borrowing any amount because he had no intention of repaying it in full. In perfect execution of his plan, his estate had many more debts than assets. Bernie Madoff seemed to have no delimiters on the amount of money he would accept, or from whom he would take it. Speculating why people would accept mortgages that they could not possibly pay, or why they would grow unserviceable credit card balances, or why businesses overpay for acquisitions with debt, is a waste of time. It is the way things work. It is like putting coffee cake out in the office kitchen. It will be eaten. Money available to be loaned will be borrowed. Maybe it is human nature.

+ Now it gets a little more confusing, even though credit is finite, it is not limited by savings. Yes, credit can be the transfer of money from saver to borrower or, as Mankiw says, “the supply of loanable funds comes from national savings including both private saving and public saving.” However, as we all know, with the possible exception of economists, credit can be extended without savings. For example, I can sell you my dog in exchange for a $100,000 note and I can buy your cat for a $100,000 note. In the transaction, we have actually traded a dog for a cat, but in the process we have just created $200,000 of credit without a nickels worth of savings. And, most importantly, we have both increased our “net worth” by $100,000 because the “value” of our pets, like stocks, is determined by its most recent sale price, which was $100,000. The long-forgotten economist, Ludwig von Mises, from long ago and far away, called this the creation of pseudo-wealth. Wall Street mavens realized that this non-economic credit creation is powerful stuff, if they could just bring it to the next level. That is to say, if in our example, they could get the rest of the economic players to accept that the value of these loans and assets are real, they could swindle the real economy out of $200,000. They would have increased their claims on the real economy without contributing anything! It would be modern day alchemy!

So, once the principles of the scheme were understood by the masters of the universe, it was only a matter of getting the broad economy to accept the uneconomic prices of assets as value. This was accomplished by attacks on many fronts. First, they let the majority of the people in on the scheme. The public participated from rising stock prices in their 401(k)’s and appreciating house prices. They provided huge financial incentives to bankers, brokers, hedge funds, and industrial management through bonuses, incentive compensation and stock options to promote the scheme. They contributed billions of dollars in political contributions to politicians to deregulate the financial industry and turn their back on oversight and enforcement. They created over-the-counter derivatives, a first cousin of credit, with no regulation and minimal disclosure to accelerate the process. They co-opted the media, particularly special purpose business publications and cable TV channels, to be cheerleaders for the swindle by ever touting the promise of a free lunch while pimping the inflated assets as investments. They developed a co-dependant relationship with certain fundamental religious groups that believe, if you make money, God must be pleased with you. And if you are poor, it must be God’s way of sending a message of his disfavor. And finally, they corrupted education and, the very economists themselves, through endowed chairs, book deals, speeches, consulting work, and important government positions.

+ An important net affect of this scheme is that it leads to a massive transfer of wealth from those wage earners, who have limited financial resources, to those who have large amounts of financial capital, executives of publicly traded companies and the participants in the execution of the scheme in the financial industry. The fellow travelers in government, media education, and religion also get a piece of the action.

+ The scheme, which is essentially a Ponzi scheme based on credit, requires ever increasing amounts of credit and derivative creation to sustain the game. The game comes to an end when the financial world finally comes face to face with the real world. In our case, reality gained the upper hand when the middle class could not afford the mortgages for the inflated value of houses.

Economic choices
In summary, the problem is not liquidity in the financial system; the problem is insolvency! The financial assets have much greater nominal price than the real economy can support.

Now lets get back to the issue of why banks loaned, without hesitation, when things were booming, but now are so reluctant to loan. Remember, the banks have a primary objective of being repaid. During the boom times, they knew they were involved in Ponzi lending. They assumed that their uneconomic loans would always be taken out by someone else as credit continued to expand and the underlying assets continued to inflate. Further, since everyone was participating and, in such huge amounts, if things did get rough, the government would come to their rescue. This was rationale analysis from an individual banks perspective, even though in aggregate, it had a devastating impact on the economy.

The reason they are reluctant to lend today, without explicit government guarantees, is again, their concern about being repaid. The Ponzi scheme is over and they are wary that they may be back to economic lending. And, since assets are still overvalued and there is still the overhang of unserviceable debt, they believe that new loan opportunities are too risky. Further, they are attempting to build their financial base by increasing capital and reducing loan exposure. The banks are not dumb. They are highly skilled in credit evaluation when it is in their interest. In fact, they should be encouraged to only make economic loans. The last thing we need is to add to our problems with more bad loans. When the financial markets are finally washed out, and the economy is on the mend, they will be happy to loan again. No, hitting the banks over the head for not making more bad loans is not the solution.

Finally, since the problem is insolvency of our financial system caused by unrestrained credit creation, the solution is to collapse the over-inflated financial assets. Bailouts merely legitimize the pseudo-wealth created by unrestrained credit expansion by socializing it. It charges all of us, as citizens, to pay for the phantom wealth that never should have been created in the first place.

The AIG scandal illustrates the fallacy of bailouts. Although everyone is upset by the $165 million in bonuses being paid to AIG executives who were poster boys for financial malfeasance, it only amounts to 1/10th of 1% of the money we have funneled into AIG in the last few months. This money was provided by the Fed to pay non-economic claims to banks and investment firms.

Up until now, the Fed has refused to disclose where the $2.3 trillion they have thus far spent has gone or for what purpose. Their arguments for non-disclosure are sophistry. They know that if it were revealed, everyone would realize that they will never get this money back. They were merely bailing out financial players with worthless assets and speculative bets.

AIG just now disclosed that the first $100 billion of Fed money went to pay, among others, foreign banks more than $50 billion for credit default swaps (CDS). More than 80% of CDS are established for speculative purposes. Ironically, Merrill Lynch and Goldman Sachs, also recipients of bailout funds, received more than $12 billion and $6 billion respectively from Fed funded AIG payments. There is no repayment from payoffs for credit default swaps!

Now, the argument given by the government for these bailouts are that, without them, the entire financial system would collapse, or as they like to say, it would foster systemic risk. Bailouts or financial collapse are false choices. Instead of giving non-discriminating bailouts, the government could let these insolvent financial institutions fail and then make direct grants or loans, where necessary, to avert total collapse. It could be considered a controlled demolition. Though painful, it would reduce the total cost to the government, and most importantly, would destroy uneconomic claims necessary to bring the real economy and the financial system back to balance.

In their own right, bailouts fail under any circumstance. If, in the unlikely scenario, they do reflate the financial system, the bubble would still exist and huge amounts of additional credit would be needed to get the economy expanding again. The bubble would just be bigger for the next bust. The amount of credit required to perform this would surely bankrupt the country by making the U.S. dollar worthless and would chase away foreign investors and central banks who own 60% of our Treasurys. The total amount of bailouts necessary to reflate is unknowable but it is more that we can withstand. Remember, our total GDP is $14 trillion, while our total debt is more that $60 trillion and the unregulated derivative monster in the back room has half a quadrillion-dollar nominal price tag, including more than $50 trillion in credit default swaps. In more specific terms, although they will not disclose the total extent of its liabilities, continued AIG bailouts alone could possibly bankrupt the country. On the other hand, if the bailouts are insufficient, the financial system could crash in any event and we would have put the country further in hock for no good reason.

Preferred course of action
The following suggestions are no sure plan for success, but are improvements over the current misguided programs currently being instituted by the government. For those of us with some capital − OUCH!

+ Discard the wrong economic theories that focus on liquidity rather than on the real culprit of excessive credit. Recognize that the real problem is insolvency of our financial system. We must continue to deflate financial assets to bring them in line with the real economy.

+ Get rid of the economists and government officials who are incapable of understanding our situation and bring in realists who can address our problems based on rational thinking and facts rather than goofy economic theories or political dogma.

+ Fully disclose where the government (including the Fed) money is being spent. Disclose the purpose of funds spent, and reveal the prospects for repayment. Disclose how the money spent affects our long term economic prospects.

+ Use the government funds in stimulus programs that put people back to work and provide economic value rather bailing out institutions and individuals with worthless assets.

+ Stop the uncontrolled bailouts and let firms fail if necessary. This controlled destruction will provide the necessary pruning of our financial system.

+ Use discretion in directing funds to those that can not financially survive the fallout, save worthwhile businesses, and exact programs that will reduce chain reaction bankruptcies.

Gordon Ringoen, a retired investment adviser, is an entrepreneur and college professor who lives in San Francisco.

Views are as of March 19, 2009, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.

Gross Domestic Product (GDP): A broad gauge of the economy that measures the retail value of goods and services produced in the United States.

Federated Equity Management Company of Pennsylvania


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