Geithner's False Assumption - Rebuilding Securitization Market Is Good for Economy

There is nearly universal agreement that the opening salvo of the Obama Administration's campaign to restore health to the financial system, delivered last week by new Treasury Secretary Geithner, fell with a loud and ugly thud. The most common criticism is that the announcement was short on detail. What is abundantly clear, however, is that the new Administration intends to push spending back up to pre-crash levels and to fill the entire credit void that has disappeared into the black hole of the American financial system. Whether or not the prior levels of spending and lending were justified by market conditions then, or now, appears to be largely unexamined.

In the worldview of Geithner and like-minded economists, credit, rather than savings, is the central figure in the economic equation. Therefore, he sees anything that eases the process of lending to be an effective economic policy. With such a view in mind, the centerpiece of Geithner's plan is the commitment of up to $1 trillion to revive the collapsed market for securitized debt. In the lead up to the Crash of 2008, securitization more than anything else permitted Americans to borrow more than they had ever borrowed before.

Developed primarily over the last 10 years, securitization permitted loans of all shapes and sizes to be packaged into investment-ready securities. The system worked, fueling unprecedented levels of lending in the home, auto, student, and credit card sectors. But in the last few years, as the collateral underpinning these securities has collapsed in value, the trillions of dollars of securitized debt now in circulation has become the toxic sludge at the bottom of our financial pit. Geithner is making the false assumption that cleaning up and rebuilding the securitization market is a prerequisite for a healthy economy.

Our nation's short history with wide securitization has simply shown that the process can lead to massive mispricing of assets and risk. By artificially rebuilding the securitization market, and committing taxpayer funds as collateral, the U.S. economy will be pushed farther and farther out on a leveraged limb, until no amount of market medicine can prevent a total economic collapse.

In truth, the only vital function provided by securitization was that it offered foreign savers a pathway to lend directly to American consumers, and Wall Street executives a new asset class to over-leverage for massive profits. Our economy must dispense with these gimmicks if it hopes to pursue a meaningful recovery.

After more than a decade of unsustainable borrowing and spending, the private sector is currently attempting to restore balance through reduced consumer and mortgage credit, greater savings, and lower asset prices. With its trillions of dollars of credit injections and stimulus programs, the government hopes to allay this process by force-feeding Americans a diet of more borrowing. They feel that a restored securitization market will help. It won't. It will just grease the skids for a quicker collapse.

Credit, whether securitized or not, cannot be created out of thin air. It only comes into existence though savings, which must be preceded by under-consumption. Since savings are scarce, any government guarantees toward consumer credit merely crowd out credit that might otherwise have been available to business. During the previous decade too much credit was extended to consumers and not enough to producers (securitization focused almost exclusively on consumer debt). The market is trying to correct this misallocation, but government policy is standing in the way. When consumers borrow and spend, society gains nothing. When producers borrow and invest, our capital stock is improved, and we all benefit from the increased productivity.

Consumers default on credit much more frequently than businesses. This is because businesses typically use loans to expand, and then have greater cash flow to repay the debt. In contrast, consumers typically borrow to consume and in the process do not improve their ability to repay. As a result, one would expect consumer credit to be harder and more expensive to obtain. But that is currently not the case. Government guarantees have altered the playing field, so that now consumers are still being offered credit while businesses are being shown the door. By shifting credit away from producers, fewer goods and services will be produced for consumers to buy and fewer employment opportunities provided for them to earn money with which to buy the goods.

To restore prosperity, credit (derived from savings rather than a printing press) must flow to producers. Greater liquidity for business will lead to legitimate job creation, increased production, and rising living standards. By further encumbering the economy with burdensome regulation, and by transferring business decisions to vote-seeking politicians who will bail out the irresponsible, reward failure and punish success, the government will create a society destined for misery.

In an interview following his announcement, Geithner stated that government should replace the demand lost by the private sector. However, those with even a marginal grasp of economics know that demand is unlimited. It is the ability to spend that is not. While Americans still want all the things they wanted years ago, they have made the rational choice that they can no longer afford to buy at the same levels they once did.

Using a printing press to replace this lost 'demand' will simply cause consumer prices to rise. Printed money does not create new purchasing power, but merely redistributes it from savers to borrowers. And since the plan will severely undermine the real productive capacity of our economy, there will not be much purchasing power left to redistribute!

Comments

[John Petersen:]

Personal experience always trumps governmental policy and each of us has to learn (preferably in young adulthood) that credit financed current consumption is invariably more painful than delayed gratification. With as much pain as the current recession has already caused, I think future borrowers will be far more responsible and the government will find itself pushing a panacea that nobody wants.

Feb 15 05:16 AM

[CautiousInv...:]

An expansion in TALF is just one leg of TARP 2.0. It is ironical, though, the program depends on many of the practices that helped to fell Wall Street firms in the first place, such as leverage, structured-debt investments and a dependence on credit ratings.

Also, many hedge funds are eager to avail themselves of this facility but the White House has promised more transparency in how its funds are used. But lending to unregulated hedge funds may prove problematic because their operations are opaque.

Feb 15 07:06 AM

[rm:]

[When producers borrow and invest, our capital stock is improved, and we all benefit from the increased productivity... Greater liquidity for business will lead to legitimate job creation, increased production, and rising living standards.]

Okay, but if the American consumer has borrowed more than he can pay back as you've previously stated, then where does the demand for goods and services come from?

Feb 15 08:09 AM

[fatcat:]

Don't forget,every day millions die,and millions of young(unencumbered by debt)burst into the marketplace,all over the world.Demand will return,just in what form...maybe not Mcmansion or Hummer demand...


On Feb 15 08:09 AM rm wrote:

> [When producers borrow and invest, our capital stock is improved,
> and we all benefit from the increased productivity... Greater liquidity
> for business will lead to legitimate job creation, increased production,
> and rising living standards.]
>
> Okay, but if the American consumer has borrowed more than he can
> pay back as you've previously stated, then where does the demand
> for goods and services come from?

Feb 15 08:43 AM

[Aristophanes:]

Over-consumption flipped is misallocated demand in certain sectors. Too large houses, granite countertops for earners making $1 above minimum wage, Hummers, etc.

There will always be a baseline (food, base materials). Too much productivity went into consumer goods for ephemeral returns based on status, greed, silliness. Securitization lumps legitimate goods based on real productivity with leveraged goods bought on consumer credit or over-extended mortgage credit.

Securitization is evil. It's lack of transparency is an economic black hole.


On Feb 15 08:09 AM rm wrote:

> [When producers borrow and invest, our capital stock is improved,
> and we all benefit from the increased productivity... Greater liquidity
> for business will lead to legitimate job creation, increased production,
> and rising living standards.]
>
> Okay, but if the American consumer has borrowed more than he can
> pay back as you've previously stated, then where does the demand
> for goods and services come from?

Feb 15 09:39 AM

[john s. gordon:]

interesting article in washington post this morning about the need for nationalizing the banks....
> jack

Feb 15 10:02 AM

[tdillian:]

great article...

pretty funny... 2 of my friends had the same experience the same day..

one goes into Bank of America to deposit some money, on the way out she is stopped by one of the BoA employees, who was at a booth, and was pressing my friend to open up a credit card account with them.

Then my other friend, she has an acctn with citibank, the same thing happened with her.

they are both now saving more and really not interested in more credit cards.. in fact they are cutting back a lot.

what amazes me is all these idiot politicians were yelling at the banks that you are hoarding cash and not lending to people.. have even considered that maybe people like my friends, and I am sure millions others, no longer want that debt, they don't want to borrow more money, no matter how much it is shoved in their faces?

Feb 15 10:28 AM

[know nothing:]

It seems today accountability is the issue here, with the U.S. goverment trying to spend their way out of a spending hangover, and hanging other countries with our debt burden,our irresponsibilty is not going to be tollerated much longer. The wall street guru's, banksters, and politicians have just about used up their relationships with our trade partners.

Feb 15 10:59 AM

[mike jacobs:]

Securitization is the genesis of the whole debacle. The root cause is that nobody was loaning their own money and the originators could have cared less whether the mortgages ever repaid. The misdirected incentives were earning fees and repayment was a "downstream" problem. The demise of securitization will be a good thing as this will mean that the catastrophe will never happen again. Lenders will be loaning their own money and they will be careful to not loan to deadbeats. Look at it this way,the housing price collapse will mean that lots of young people will be able to afford homes that could never afford an inflated priced home.

Feb 15 12:05 PM

[t-bird:]

Mr. Schiff wrote:

"When consumers borrow and spend, society gains nothing. When producers borrow and invest, our capital stock is improved, and we all benefit from the increased productivity."

Case in point the departure from the US in the 90's of our mfg. base whether it be home furnishings, textiles, even call centers etc.
The Administration's willingness to "spend" their way out of this mess may in fact result in short term gain; but I feel will be long term pain, with one of the results being a significant increase in hyper inflation...In preparing for the future, I hope for the best, but prepare for the worst!

Feb 15 12:16 PM

[H. T. Love:]

Fatcat spake:

"Don't forget,every day millions die,and millions of young(unencumbered by debt)burst into the marketplace ..."

Wrong! They and their grandchildren are already "encumbered". The current stimulus and "bailout" plans will only increase the encumberance. However, somewhat like Pavlov's dogs, the average person does respond to both negative and positive consequences. The recent spike in personal savings is the first positive sign (how long will it last? Who knows.) that regardless of the politicos, the American psyche may have been changed for a long time.

This offers a ray of hope, however small.

As "investors", rather than traders, it is our "job" to reinforce this new attitude to help combat the misguided exhortations of the government.

If we succeed, a new dawn may yet arise.

HardToLove

Feb 15 12:53 PM

[Jay-Dawg, CDA:]

It's sad to see that politicians, no matter from which party, just don't seem to get it.

George W. Bush, back in 2001-2002, went on national television many times encouraging Americans to go out and spend, saying it was the patriotic thing to do. Now, Barack O'Bama seems to be doing exactly the same mistake: encouraging consumers to borrow and spend instead of businesses.

Mr. Schiff is 100% correct when he states that it is generally businesses, not consumers, that create value by borrowing. Businesses are the best in selecting projects with positive NPVs, whereas consumers are not (maybe buying a 60" plasma TV on credit was not such a good investment after all!).

Of course, higher consumption leads to greater incentives for companies to innovate and better respond to to consumers' needs, but the reasoning is upside down... It's supposed to be innovation from companies, fueled by a strong local savings rate, that lead to higher demand. If borrowing occurs mainly at the consumer or governmental levels, businesses are simply crowded out can no longer invest.

Jay

Feb 15 01:25 PM

[Pink Panther:]

rm:
If America produces more stuff, which can be sold successfully around the world (not Silverados or Hummers but tech stuff like iPods, solar technology, chemicals, biotech, where America's got an edge), I think there would be a lot of demand and would reduce the trade deficit a great deal.


On Feb 15 08:09 AM rm wrote:
> Okay, but if the American consumer has borrowed more than he can
> pay back as you've previously stated, then where does the demand
> for goods and services come from?

Feb 15 01:48 PM

[hardymaine:]

Schiff makes a good point that it would not be desirable to restore the irresponsible use of credit that was going on prior to the financial ystems near collapse.

But he overlooks the fact that wild use of credit went on because greed was unchecked due to the complete absence of reasonable and necessary government oversight. If he is concerned the pendlum could swing to far toward regulation I agree. But I think the financial crisis demonstrates that the government was too hands off and now we all are paying the price. If we would only work together we actually could get some useful reforms out of this crisis. Democrats and Republicans should check there ideolgical bagage at the door and focus on fixing the financial system.

I for one am also tired of hearing people complain about Geithner's lack of detail. I would suggest that they could help the country more by offering concrete suggestions that the Treasury Secretary could draw upon.

So far Wall Street's ideas seem to me to be contradictory and not very well thought out. On the one had, the Street seems to want to have the Government buy the bad assets yet the Street wants to betrate the government for spening too much money on a program to do so and at the same time the Street seems to argue that they don't need Government help. Government is an easy target, But Government over regulation did not cause this mess.

Finally, Schiff's argument that printed money won't trigger real demand is way off. With some 11 million workers idle there is a lot of labor that can be used to create real goods and services before we have to worry about inflation from too much money chasing too few goods and services
Real ecomomic waste results form the 11 million idlle workers.

Feb 15 01:53 PM

[Nik Kondrat...:]

Credit is an essential element in the smooth flow of a capitalist system. The problem in the U.S. has been the over securitzation of credit--affording gross disconnects between risks and rewards--and the attendant lack of regulatory oversight of the CDO, CDS, and derivatives markets. This created a capitalist boom cycle not unlike previous boom cycles (land, gold, oil, tech stocks, etc). Except this time the boom was in esoteric credit derivative products that nobody understood the real risk/reward ratio and there was NO mechanism to regulate these things because the CFTC pushed hard to exclude them. And, like every other boom period this one was followed by a bust. Except this time because the credit boom permeates virtually every aspect of our economy, and because the financial institutions for whom this became their currency-in-trade are at the foundation of our economy, we are standing on the edge of a catastrophic bust.

I think Peter's right in his description of the problem with TARP 2.0 and his notion that nobody on the Obama team has even considered the option that the status quo ante was not good for our economy and is therefore a gravely misguided policy outcome.

As I've said in other comments, Obama needs a new team of economic advisors. This team is going to wreak even more havoc.

Nik

Feb 15 02:49 PM

[athena:]

Securitization is not the problem, it is the insurance (swaps) that allowed for large sales of toxic securities. Blame anything you like but these toxic securities could not have been sold in quantity to anyone without the swaps to insure them.

Feb 15 04:28 PM

[Aristophanes:]

Securitization is precisely the problem. Loo at the word. It is supposed to enshrine security. The entire product is supposedly guaranteed by irrevocable contract, good until final redemption. This would apply if there was no insurance swaps also covering the positions. Lawyers vs. insurers is the main difference.

if these things were not so "secure" they would have been broken up already into separate mortgages to be handled the"old fashioned" way. That this option is not on the table is ridiculous. It is the ONLY transparent way to value these assets. and end the foreclosure crisis.

Divided we fall: that's the motto behind securitization.


On Feb 15 04:28 PM athena wrote:

> Securitization is not the problem, it is the insurance (swaps) that
> allowed for large sales of toxic securities. Blame anything you like
> but these toxic securities could not have been sold in quantity to
> anyone without the swaps to insure them.

Feb 15 07:59 PM

[Rob Viglione:]

Peter, excellent picture of the consumer credit problem! I had never considered the fact that Wall Street facilitated unprecedented growth in consumer credit, particularly by channeling foreign savings. This certainly left the producer side of the equation under-capitalized relative to consumer spending. As we must all remember, you cannot have credit and spending without first having savings.

Feb 15 08:58 PM

[Fred Voetsch:]

On Feb 15 01:53 PM hardymaine wrote:
> I for one am also tired of hearing people complain about Geithner's
> lack of detail. I would suggest that they could help the country
> more by offering concrete suggestions that the Treasury Secretary
> could draw upon.

That's a ridiculous statement. This man has all the input he needs and is supposed to be a foremost expert in his field. If he suceeds then he is a hero, if not he is a goat; that will tell the story.

The problem, however, is that this man is just another of those who got us to this point in the first place and he may well be incapable of getting us out of this mess because he cannot see the forest for the trees. He is too deep in the forest and its not his type of tree that is burning so he just doesn't, and can't, get it.

Feb 15 10:37 PM

[zanardm:]

Debt of Cards

The more debt the gov runs up, the higher yields rise, and hence interest rates. Therefore this further shuts down the housing market. Why not get debt down, yields down, and hence interest rates down for houses, cars, and consumers in general? Thus the quickest way for the economic tide to rise for all of us? Is this too simple a plan to advance and execute? Forgot about the big banks; most of the banking system (8000+) is stable.

Feb 15 11:27 PM

[Aristophanes:]

Not only that, but cheap credit was used as a substitute for labour price distribution.

In other words: Why pay people more when they can borrow more? Forget sharing the benefits of productivity with the workers; save that gain for the executives and the "investor class". So you had Wal-Mart using corporate buses to take their own employes to food banks. Any outlet to drive wages down and profits up.

Start by advertising to everyone that the equity in their house would alleviate the need to increase their take home pay. Blame government taxes for your real financial troubles.

Thus, productivity gains went up the corporate ladder and the middle class became heavily leveraged as a wage substitute. That's why income disparity reached such incredible levels in the last 20 years. And NOW we're having a discussion on executive pay. Perhaps more shareholder rights and a more equitable tax system with, like, no loopholes in the first place would have been better? Would that be too much to ask?

While corporate America was at it, they gutted the pension system, and are in the process of gutting the health care system as well.

Mindless ideology will cause a revolt destroying the very capitalist values the ideologues intended to have triumph. Such are the unintended consequences. I'll enjoy seeing hedge fund manager nuts get cracked by federal agents holding a weapon at the suit. but, of course, we "don't disparage wealth", do we?

On Feb 15 01:53 PM hardymaine wrote:

> Schiff makes a good point …
> But he overlooks the fact that wild use of credit went on because
> greed was unchecked due to the complete absence of reasonable and
> necessary government oversight.

Feb 15 11:53 PM

[Steven Hansen:]

I am wondering where all this ends up. i am sure through lowering of interest rates and taxes, a renewed credit expansion cycle can be generated. it is not sustainable, and will make matters worse then they are today at some point.

i cannot believe the government is that stupid so they have to be banking on something else happening to trigger the economy. i just cannot think what it could be.

unfortunately, the government stupidity is demonstrated every day so i tend to think things will turn out as Peter suggests.

Feb 16 01:01 AM

[Seen All It...:]

Amen

Feb 16 01:52 AM

[Boubou:]

I think these ideas are credible and clearly expressed.
Unlike many recent official statements.
When officials don't know what they are talking about it comes out in garbled English laden with jargon and metaphors, and with over emphasis substituted for convincing logic.
Funny thing about Peter is that he comes across as a bit of a salesman at times when speaking, but the prose is compelling.
I bu this

Feb 16 09:58 AM

[mr freddo:]

Thanks for a very good article Peter. The securitization of consumer debt created a "new paradigm" for consumers, much like those Internet stocks valued at 100x sales in 2000. Unfortunately, although credit availability skyrocketed, the ability to pay it back did not.

Now the consumer has crawled under a rock and, if still working, is saving money and paying down debt. Nothing the government does will change that. There is no gas in the tank...yet. The consumer driven economy won't recover until savings recover.

What is the proper role of government? Reduce spending? Shrink the deficit? Provide relief to the unemployed? While a reduction in spending sounds like Hoovernomics, adding to our debt burden substantially cannot be the answer.

One thought is to ask Japan to forgive the trillion we owe them in exchange for the defense umbrella we provide. Ditto Germany.

Take that trillion and give it to the top venture capital firms to invest with the same terms that vc investors get. Recovery would take years but at least we would have new googles and apples to employ people.

Feb 16 07:53 PM

[Rob Viglione:]

"One thought is to ask Japan to forgive the trillion we owe them in exchange for the defense umbrella we provide. Ditto Germany."

Why not cease providing this "defense umbrella"? WWII ended in 1945.

Feb 17 12:19 AM

[brooksie:]

dude, i lost my ass listening to peter schiff. i know hes one of the smartest guys in the room but please lets not revere him. he's been wrong quite abit over the last year and maybe his scenario will play out but i got out awhile ago and im waiting to see what happens. every currency is debasing so whats the answer as the dollars strengthens daily? do i really want dividends in canadian dollar or swiss francs when the system is collapsing. maybe its time to buy a farm, a gun and protect my family with gold and silver burried. i see the EU going into the depression first as germany and france refuse to budge. i agree with their philosophy but i could be out another 40% until the rest of the world realizes it.

Feb 18 06:35 AM

[bones33:]

I'm buying gold,guns and groceries and storing them in my bunker.I call it the 3 g's financial plan.

Feb 23 07:31 PM

[samwise:]

securitization is evil? i didn't even know what it was until wall street collapsed. i did understand that we were giving Japan, Germany and finally China worthless pieces of paper and they were giving us Toyotas, BMW's and gadgets I didn't even know existed until I could buy them at Circuit City for $199. Evil? I've been told somebody in Singapore has a claim to my toilet seat. All I have to say to that is when I default I'm gonna fight for that sucker. I do understand the problem now is that we're actually using OUR REAL MONEY to bail out the FUNNY MONEY. Someone should stop that! But while it was going on it made me feel like Austin Powers--you know, "yeah, baby--yeah!" And besides, aren't Geithner and Emmanuel like two minnie-me's? Every cool guy I know has a midget friend. And BO has TWO! BO's not just cool. He's SUPERCOOL.

Mar 10 12:10 AM

[storm999:]

The issue was businesses were not getting credit and otherwise qualified borrowers could not get mortgages due to risk aversion over housing prices etc.


On Feb 15 10:28 AM tdillian wrote:

> great article...
>
> pretty funny... 2 of my friends had the same experience the same
> day..
>
> one goes into Bank of America to deposit some money, on the way out
> she is stopped by one of the BoA employees, who was at a booth, and
> was pressing my friend to open up a credit card account with them.
>
>
> Then my other friend, she has an acctn with citibank, the same thing
> happened with her.
>
> they are both now saving more and really not interested in more credit
> cards.. in fact they are cutting back a lot.
>
> what amazes me is all these idiot politicians were yelling at the
> banks that you are hoarding cash and not lending to people.. have
> even considered that maybe people like my friends, and I am sure
> millions others, no longer want that debt, they don't want to borrow
> more money, no matter how much it is shoved in their faces?

Mar 12 05:38 PM

[storm999:]

If we do not restore the credit markets -securitization to some degree, then massive deflation will occur. That is the problem. As Schiff points out securitization gave foreign entities a conduit to the consumer. This is a cosequence of the dollar being the reserve currency and mercantilist nations trading with us. It also was spurred on by Reaganomics which allowed declining real wages to be replaced with subprime credit.

To be fair the Obama administration wants more regulated banking, higher real wages for workers and has already scolded China for mercantilist currency manipulations. In their world, consumers will have access to credit through well-regulated markets and underwriting restrictions will eliminate predatory lending (or ponzi lending as Minski called it).

If Geitner had said he was going to flush the credit markets down the toilet, then the S&P 500 would be trading at 350 right now. There isn't one company in the S&P 500 that doesn't provide consumer or commercial credit and then sell it on the secondary market. The world business model is built on credit and inflation, not cash and deflation.

Mar 12 05:49 PM