Messrs Paulson, Bernanke, Bush, Reid, and Mrs. Pelosi.
(Edited and slightly revised on 10-11-08)
We’re always deeply suspicious when a politician tells us how he or she is going to “fix the economy.” The best they can do is get out of the way, but unfortunately they rarely do. That’s the sinful, human problem created by that all-too-common combination of hubris and ignorance.
As we mentioned in a previous post, the most honest moment of the current Presidential campaign was an ad in which McCain admits that he doesn’t know much about economics, and it was an Obama, Anti-McCain ad.
If only, if only, McCain would act in the humble spirit of that ad. Instead he announces a new bailout plan for those who can’t pay their mortgages. It is an admirable sentiment. Unfortunately, it is likely to be very unwise (given the way such programs are implemented).
We ask: if you’re close to defaulting on your mortgage, why struggle? Why liquidate retirement accounts, why take a second job, cut entertainment costs or pare down vacation budgets? Why not default dear reader and let the government pickup the difference? We haven’t looked at the specifics of his plan, but we would be very, very surprised if it didn’t introduce such dysfunctional incentives for those struggling to make their monthly payments.
But Mr. McCain’s latest misstep isn’t why we’re writing.
This evening, (Thursday, October 9) we saw this headline on The Wall Street Journal‘s web site: Treasury Weighs Next Step to Stem Crisis.
Isn’t it obvious? Isn’t it time for Mr. Paulson to go? And Mr. Bernanke, too, over at the Fed? (Except for next three plus months with Mr. Bush, we seem to be stuck with others–kind of like our shoulder bursitis or chronic disc problems.)
Do you think the markets would react negatively to those resignations? We doubt it. Would you? Would they?
They’ve made any number of mistakes since 2007, and below we try to categorize the collective errors into as few groups as possible. In our opinion:
- The gang misspecified the initial problem. This might have been due to the fact that Paulson and Bernanke may have been too close to the situation and much of it involved their friends, former colleagues, acquaintances, and probably their neihbors. The rest the gang missed it because they seem inherently clueless.
- They had/have no viable solution to the misspecified problem, let alone the real problem. We’ve written extensively about why the bailout would fail and, in fact, how it would lengthen and deepen the crisis. Try this link or just go to the blog; many of our recent posts have talked about these issues. The real problem is no one trusts the banks.
- They overstated and (generally) overreacted to the initial problems. It was like screaming that a flaming wolf was falling with the sky in a crowded theater of sheep and chickens. Well, we’re seriously mixing our metaphors but their cries of ”wolf” and “the sky is falling” were like shouting fire in a theater, whether or not it is true. They were wrong, yet created fear nonetheless. Quite a feat to be sure.
- They had no understanding of the implications of their overstatements. It seems that their initial overstatements were mere rhetoric designed to get their misguided bailout bill passed into law, but words have implications, too. Those words weren’t very confidence-inspiring. In fact, at the time and in retrospect, those words seem(ed) to be panic-inducing because the solution seemed (seems) very hokey to many but investors remembered the words of fear, especially in the context of a doubtful plan. In other words, investors seemed to believe that there was a problem but didn’t seem to believe the existing bailout or its federal overseers could solve the real one. Ergo, the unprecedented equity losses.
We believe the group’s collective actions and statements showed that our government officials were and are fearful, scared, and especially clueless about true underlying problem. In fact, they seem to have made the situation worse by offering a solution that didn’t fit the problem and by forcing large banks to merge and. (See Bigger Is Not Necessarily Better for a discussion of the forced mega-mergers and the future problems that might cause.)
As we wrote Tuesday in Even A Perfect Bailout Will Fail, the problem isn’t the bad mortgages or technical defaults or mark-to-market accounting. The massive mortgages losses were the vehicle that conveyed negative information about the banks. The problem is that many banks bought the bad mortgages at very high prices (and rather recently, too) and those mortgages aren’t worth much today. The market’s judgment is that the banks should have known better.
Those mortgage-related purchases show the banks to be far less competent and far less trustworthy and far less creditworthy than almost anyone imagined just a short time ago.
It wasn’t just bad luck. It was incompetence on a grand scale. That’s what turned bad luck with possibly a small number of mortgages into a global crisis. We don’t believe that either the mortgage crisis or the larger financial crisis were inevitable, but we do believe that it is quite possible for a little bad luck, so-to-speak, to turn very ugly, very fast. (Good fortune would have prevented the problem and few would have realized the potential for it existed. That makes us wondered: how many times in the past have we been lucky, i.e., “there but by the grace of God go I?”
Given the lax (yet very common) lending standards used more many mortgages, it was easy to generate a domino-effect where a concentrated but small number of defaults (and resulting house devaluations) could have generate unbelievably-fast, feedback loops that quickly (and negatively) affect local and regional housing values, and the national (and global) economies. It appears that these feedback loops could jump across regions, say, from California to Charlotte, as we mentioned in Wachovia, the Hold-up Problem, and Feedback Loops.
It seems that no firm’s analytical models included this contagion phenomena and none of their analyses captured these neighborhood, town, and regional dependencies and interpdependencies. (See our Trading, Incentives and Organizational Structure and Risk Management from the Spring.)
Only a very small number of geographically close (neighborhood) defaults, can be treated as independent trials, like separate, unrelated coin flips.
Once a (low) threshold is met, however, it seems that everyone in the neighborhood is (negatively) affected. Such a phenomenon is often called as a tipping-point.
A few foreclosures on a street can be attributed to idiosyncratic factors, e.g., divorce, relocation, gambling, etc. However, after a critical, but still small, number is of defaults is reached, the value of many or all of the homes on the street or in neighborhood is diminished and possibly destroyed. Depending upon the fragility of borrowers’ creditworthiness, including the percentage of the value financed, these losses on a street can roll up and induce losses within subdivisions, then towns, and then regions, and then even across regions.
We’ve mentioned repeatedly that these mortgage-related losses seem to be especially concentrated among banks this time, and despite the recent massive losses in the equity markets, that still seems true. We believe this was due to lax management, including poorly-structured incentives, which led to excessive-risk taking of both well-understood products (mortgages) and poorly understood ones (MBS and CDOs). See this post, for example: Idiosyncratic and Concentration Risk, Again.
At present, it seems that few outsiders trust the banks. Worse yet, it seems that no insiders–other banks–trust each other. A few days ago, we attributed that suspicion to the equivalent of psychological projection in Financial Projection in a Crisis. Each bank projects its own diminished viability onto the others. Unfortunately, it seems many of them are making the correct inference and drawing the right conclusion. (Note: we don’t mean all banks as many, particularly the smaller ones, seem to be avoiding the current mortgage mess.)
This lack of trust among banks has led to many collateral calls, and it is why AIG, the writer (insurer) of many credit default swaps (CDS) has eaten through over $120 billion in a few weeks. (That’s seems to have been another misjudgment by the Fed.)
Certain commentators have called for establishing clearinghouses for other-the-counter (OTC) derivatives like CDS. We doubt that it could be done quickly enough to instill confidence. Moreover, that doesn’t solve the existing problem of not being able to meet margin calls today.
We’re beginning to believe that the government must act immediately to nationalize certain large banks. At a minimum, it would solve issues related to margin calls and collateral problems and eliminate the need to take other silly actions.
We’re almost an economic Libertarian, so it gives us pause to contemplate nationalizing certain institutions, but we consider such a plan to be a remedy to past government mistakes, including almost everything our government officials have done in the last month or so, and including the misguided “bailout.” (By the way, we know that government helped create the mess, and we don’t trust them to do a great job, but by definition, no one can nationalize.)
We write it partially to convince ourself, but there seems to be little left to do but nationalize those banks with the biggest reputation problems and the lowest percentage of capital to assets.
If that happens, the government needs to do it swiftly and by surprise. It needs to take 100% of their equity thereby wiping out existing shareholders. All boards and senior managers must go, too. Certain trading desks with capital markets’ departments and–where necessary–treasury departments would need to be quickly split (to the extent possible) from general bank operations. Once stabilized, the new entities would need to be sold as soon as possible.
Separately, we believe that our proposed, private solution to the mortgage crisis, i.e., A Better Solution (than a government takeover), would solve that problem, which is now a minor aspect of the bigger problem. A mere symptom of the financial industry’s bigger problem, and neither our very clever plan nor the government silly bailout will solve that bigger problem: a complete lack of confidence in many of our largest financial institutions.
The economy requires financial intermediaries that can be trusted, and the reputations of many of the current ones have been shattered; so, it seems that something big has to change: possibly they need to be taken over and then resold them. We’re not sure that we completely believe it, yet, but it is something to contemplate.
We don’t see the current crisis as a failure of markets. It was a failure of government intervention and policies at many different times and stages, with the latest ones being the most visible.
So, ossibly, a government solution is required to reverse the damage it caused?
Mr. Paulson and Mr. Bernanke must leave before that can occur, regardless of the proposed mechanism to fix the problem. They are doing nothing to mitigate the problem, and in fact seem to unintentionally exacerbate it.
We need to think more about it, but as scary as it is to write, the quick nationalization of the worst banks MAY be the cheapest and best solution.
We’ll likely continue to revise this post as we clarify our thoughts.
