Why 'We've Got To Stick Together'

After Friday's close, I lamented on the telephone with a relative whose puts had been blown out by the tremendous morning gap higher.

We discussed at length why liquidity is so important to our system that the government felt it had to take these drastic historic measures to shore it up.

To summarize, while the markets will likely fret for some time about what the Feds imagine is so bad that this was necessary, the implications of inaction would possibly have gone far beyond allowing another few mega-banks and insure-cos to fail, threatening the very roots of our capital market structure. I don't wish to be a doomsayer here, but obviously only time will tell whether the measures will prove effective.

Flawed Case-by-Case Approach

Looking back, as grating as Friday's actions were to our free-market foundations, they probably should have been taken earlier in the summer. I don't think the Feds necessarily had to blow out the shorts on an expiration Friday to make their point once again, but maybe the Brits spilled the beans early and yesterday was, after all, a pretty scary day.

The government simply could no longer keep addressing one institution at a time, leaving us all to wonder who would be next while playing "wait-n-see" and jawboning about how "no institution is too big to fail." That next institution may well have otherwise been the very system itself.

First, the government needed to put in place blanket structural measures covering the entire system to avoid going further down that slippery rabbit hole of articulating what criteria it would apply in selecting its next salvation candidate. It was the only way to avoid ever shifting statements and precedents, thus preserving its own (remaining) credibility.

We Are a Levered Economy

More importantly, it was not just that our banks were (and possibly remain) scandalously over-leveraged at 30:1, turning 3% excess loan losses into 99% black holes. It is that: a) the largest of our institutions are inextricably interlinked; and, b) our entire economy is fundamentally based on leverage of varying degrees.

When people can't get loans to buy homes, companies can't affordably draw on their revolvers, and banks stop lending to each other altogether - without hyperbole - the whole house of cards is likely on the verge of collapse.

Let's think about it. Even at traditional loan-to-value ratios, 80% has been typical in the home loan market for decades on end. In the sixties and seventies, tremendous additional float became available to the consumer with the advent of credit cards, not to mention home equity loans in more recent times. And the same can be said of businesses and commercial loans. Leverage is a significant part of how new opportunities are explored and expansion is financed. In the long run, we know that GDP and aggreggate growth are one in the same.

I could go on further tangents here on the role that the ratings agencies, derivative and reinsurance markets played in all this (a true laissez-faire corporate "race to the bottom" and "tragedy of the commons" all at once led by a complex interaction of individual, corporate, industry and government motivations), but this is all surface noise. Let's instead go a bit deeper to the root of the Fed's true fears.

The Multiplier Effect & Tipping Points

Fundamentally, every dollar that is spent and job that exists in our economy is subject to an economic multiplier. It's Econ-101. Think about it this way, for every one job lost at Lehman Brothers, how many building maintenance and security worker, limousine driver, maid, nanny, dry cleaner and barrista-down-the-street jobs are also lost? Two, three, more?

At some point along the path of economic and market declines, it is easy to imagine how we as a nation become increasingly sensitive to these losses on the margin. The multiplier works exponentially against us at some critical tipping point. We have been going down that road for nearly a year now, recently with increasing acceleration. I have to think that some fairly grim scenarios based on this logic were at the root of Paulson's nightmarish cautionary tales reportedly told up on the Hill last night.

Boom to Bust & Capital Market Cracks

Sure, it feels bizarre that we went from such a flush period to the polar opposite in such a short period of time, but, as is often the case, it was truly the unregulated excesses of the last expansion that set us up for a bubble correction leading to this traumatic and unprecedented decline in housing.

Yes, it was also predicatable, but if you'd bet on that since '06, you'd only now be breaking even on the trade. Back to my earlier point, this effect could only travel so far before that fundamental multiplier effect would waterfall over the entire global economy. Delinking debunked -- have you looked at emerging market performance lately!

Lastly, with the debt markets done in, by definition equity has to be shot as the unprotected asset class. No IPOs or stock financings here, thank you very much. (Not to mention foreign capital injections!) It seems that realization may have finally begun to sink into the equity markets just this week. Heck, even the repo money markets became unstable. When the lower traunches of the system are in shock, the entire capital markets structure trembles.

Folksy Blog Insert [Here]

A straighter title to this post would have been, "Why Liquidity Matters." I'm no economist, and though I suppose I could go into greater detail on why this is all so, there is really no need because the George Baily (James Stewart) character of the 1946 classic, "It's a Wonderful Life" said it all as plainly and passionately as could be during the "Run-on-the-Bank" scene:
 

---

"You're thinking of this place all wrong. As if I had the money back in a safe. The money's not here. Your money's in Joe's house...right next to yours. And in the Kennedy house, and Mrs. Macklin's house, and a hundred others. Why, you're lending them the money to build, and then, they're going to pay it back to you as best they can. Now what are you going to do? Foreclose on them?...Now wait...now listen...now listen to me. I beg of you not to do this thing.

If Potter gets hold of this Building and Loan there'll never be another decent house built in this town. He's already got charge of the bank. He's got the bus line. He's got the department stores. And now he's after us. Why? Well, it's very simple. Because we're cutting in on his business, that's why. And because he wants to keep you living in his slums and paying the kind of rent he decides.

Joe, you lived in one of those Potter houses, didn't you? Well, have you forgotten? Have you forgotten what he charged you for that broken-down shack? Here, Ed. You know, you remember last year when things weren't going so well, and you couldn't make your payments? You didn't lose your house, did you? Do you think Potter would have let you keep it? Can't you understand what's happening here? Don't you see what's happening? Potter isn't selling. Potter's buying! And why? Because we're panicky and he's not. That's why. He's picking up some bargains.

Now, we can get through this thing all right. We've got to stick together, though. We've got to have faith in each other."

---

Diversionary, yes, but Frank Capra wrote that script in the period perhaps most analogous to what we are facing today. It's like I wrote last Sunday (was that less than a week ago?) our economy is 100% based on the principals of Hope and Trust.

I'll let you decide who "Potter" is in today's story, but two things are certain:

we've got to stick together on this one... [and] we've got to have faith in each other.

(It may even be time to reread the motto on our own dollar bill -- I know, I said no doomsaying!)

However imperfect they may be, let's hope that this week's dramatic Federal actions are correct, effective, and temporary steps in reestablishing these necessary preconditions to functioning capital markets.

What Now?

After the initial euphoria fades next week, the markets will undoubtedly begin fretting over what "truth" Paulson and friends feared with sufficient probability that they felt the need to switch from the "bazooka to the nuclear device," to quote one of today's CNBC commentators.

I would suggest that it is best to nip such speculation in the bud with a full and candid characterization of exactly what was said last night up on the Hill. After all, wasn't a lack of transparency part of what got us here? It's fear of the unknown that tanks markets. If this week's measures address the grim scenarios properly, then there should be no fear of discussing them openly, and soon.

As for what this all means for the future of our country and its standing in the world, that will just have to take time to sort out. It certainly feels grim right now, and you can be sure I'll be keeping an eagle eye out on the dollar, but we have been through this before, and here we all are.

Warning: Political Theater Ahead!

Then there is that other famous George Baily quotation:

---

[To Uncle Billy] "Where's that money, you silly stupid old fool? Where's that money? Do you realize what this means? It means bankruptcy and scandal and prison. That's what it means. One of us is going to jail - well, it's not gonna be me."

---

How we got here is more complex than a sound-bite fault that can easily be attributed to any one or several actors, but no doubt there will be plenty of time for the political blame game ahead after we've addressed the crisis at hand, TARPs and all.

Thank goodness there seems to be political consensus on this. The last thing we need right now are half-a-dozen hearings about how the evil shorts and bankers took us here, please Mr. Bank Regulator.

* * * *

Comments

[JCCIII:]

Jeff. Good article and, I agree with you, continuing without an RTC-like approach is no longer acceptable. A concern among many is that people who have not been responsible will be rewarded; examples, the persons who entered into mortgages they could not reasonably afford and the mortgage companies who made those loans. Your thoughts on this concern will be appreciated. Thanks.

2008 Sep 21 01:53 PM

[jgpietsch:]

Thanks JCC, a little rough around the edges, but I wanted to get it out in a timely fashion. I share your concern in general vis-a-vis irresponsible parties... but let's take a look at those actors:

o Homeowners - I tend to think the man on the street relies to some degree on the banker to tell him what he can afford. He may think it is a stretch going in, but when a vaunted "banker" says he's good for it, it confirms his optimistic (if unrealistic) outlook. If he or she mistated assets and earnings, of course that's a different story; it's called fraud. In any event, that home owner has now walked away from 5% to 20% equity. Let's call that $10,ooo to $40,ooo based on typical median US home prices. Not small sums, not to mention the big dings on their credit records and possible bankruptcy status... enough punishment? If anything, the 5% downpayment level (on second homes anyhow), certainly made it too easy for them to walk away, leaving banks with the problem.

o Mortgage Loan Employees - Well, these guys were on commission and undoubtedly pushed more loans through than were deserved. Of course they were incentivezed to do this by their companies that paid on commission. They certainly had a flush run, but are now universally out of the job... enough punishment? To the extent we are talking about the mortgage bankers and such, look at those Lehman employees paid in stock options... now worthless, enough punishment?

o Mortage Loan Companies - On the margin, their management was incentivized to keep up with their competitors in terms of market size and share or be punished by the market. And where were the regulators? It wasn't one or two or three banks doing this alone, or even in collusion, to cover that angle, they were all making the best individual decisions to survive within the herd. Plus, it was easy to drink the coolaid that risk was being spread out appropriately anyhow through reinsurance and CDOs. Plus, like the homeowner, their ratings held up, so it "must be OK, right?" Now they are out of business, out of the job, or holding worthless stock, sufficient punishment?

o Ratings Agencies - Should have been on top of this at least two years ago. Unfortunately, look who pays them! Plus, they also no doubt bought into the notion that risk was spread out and that "real estate has never gone down before." It think this group should be held to a higher standard and realign its incentive structure for their own good reputation, if nothing else. Probably getting the least slack so far, and they deserve more, but will probably get away more or less clean.

o Regulators/Gov - Should have been on this years ago. Some voices (Greenspan) in the woods, but they were not heeded, and it's politically difficult to step in the way of the "American Dream." Which party to blame - both - even though administrative agencies fall under the Pres., Congress has oversight and failed to either understand or act. Vote them out if you can find better replacements.

o Reinsurers - These guys should have known they were headed for a train wreck. Again, look at their stock values now.

Underlying themes are misalignment of incentives, lack of regulatory oversight and/or action, a herd mentality and diffusion of responsibility. It's lame to say no one understood "the complex models," I'm sure they did. The individual models simply didn't consider the possibility of bubble creation through aggregate macro economic effects -- garbage in garbage out. Anyone that stood back and looked at the big picture was likely drowned out by idiots saying, "hey home values have never gone down before."

This is pretty rough, but you get the idea. I'm sure some individuals will get pilloried, that always seems to happen. But really the blame is diffused among so many actors, alot of pain has already been doled out, and now we all need to share in the pain to keep the system functioning.

I don't see how any one of the above parties is necessarily being rewarded here. No one that lost a home is going to get it back (unless they repurchase it for pennies on the dollar from the TARP! Maybe they should be disqualified to bid!) Equity values have plummeted and jobs have been lost, and none of those are coming back overnight. One could even argue that those who didn't sell out months ago or go short the financials should be rewarded with a small bounce. Again, if there was outright fraud or collusion proven, that's a different story.

What do you think?

2008 Sep 21 05:49 PM

[JCCIII:]

Jeff. Thanks for the response to my concern. You are right; all involved have been punished to some degree. As much as I hate to admit it, I think the answer is that more regulation must come with the government money; common sense requirements, such as, that people who take out loans must demonstrate an ability to repay, management and employees of loan companies are accountable to the share holders for the loans they make (perhaps by making a significant portion of their salaries shares of stock that cannot be sold for 2-5 years), etc. Again, thanks for the response.

2008 Sep 22 10:55 AM