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The Asymmetry of Bad Debt: Part 2 - "A Scared Man With A Bucket"

   Sailors are constantly deluged with promotional materials for new equipment.  Whenever someone comes up with some new technology for bailing out a boat which is taking on water, the question is always raised whether the new technology can beat the best technology of all - "a scared man with a bucket."   And that is exactly what we had in the Fall of 2008 and still have, to a lesser extent.
  The wealth destruction effect of bad debt moved through the financial system like wildfire in September 2008.  I think that the pundits have often missed the significance of the WAMU collapse in which non-depositor creditors were wiped out.  Within days, most bank bonds were derated and lost most of their value. One week later, Wachovia teetered on the brink of collapse and had to be taken over - but, this time, a "systemic risk" finding was made and creditors were protected.   The cost of interbank loans had skyrocketed because banks were afraid that other banks might default - this was reflected in higher LIBOR rates and, in turn, drove up mortgage rates and rates on other loans.  Terms like "systemic risk", "counterparty risk", and "LIBOR" were becoming household words - traders most likely combined mainly of these terms with expletives. 
   In a very short time, tens of trillions of dollars of wealth were destroyed. Systemic risk had reared its ugly head and it was becoming clear that, in a manner similar to that described in an HIV prevention advertisement, a creditor was not lending money only to his debtor but was actually lending money to everyone to whom his debtor lent money. The most effective strategy in such a situation is quarantine and that is exactly what happened.  Enhanced deposit insurance which protected almost all deposits and interbank loans as well as newly issued bonds was the most important single step taken by the federal government. The interbank loan coverage was the most important of all. It meant that one bank's losses no longer became the losses of the entire industry.  There was also a program to protect money market funds. Most importantly, all of this was done quickly.  The public did not have time enough to figure out the risks it was exposed to, withdraw its money from the banks and money market funds, and hide the cash under a mattress. It is possible that the onerous reporting requirements associated with large cash withdrawals may have also retarded what could have been a calamitous bank run.  
    We very narrowly missed being hit by a disasterous bank run and a total destruction of a huge amount of wealth. The federal government essentially "rented out" its balance sheet and instantaneously deposits and money market balances were no longer viewed as being at risk but were valued at their face amounts. Just as investors blood pressure was started to fall below 150, the Madoff scandal broke - leaving many investors suddenly a lot poorer than they had thought they and leaving everyone else with a fear about what was going to happen next. A little later it became clear that General Motors was about to go over the cliff - and it was a prominent Republican in the Eisenhower Administration who said that "what's good for General Motors is good for the United States."  It didn't take long for observers to realize that a corollary applied to "what's bad for General Motors."  Credit markets had experienced a series of   brutal shocks and non-insured bank bonds continued to trade at massive discounts.  Spreads on junk, intermediate and even investment grade corporate debt were at record levels. Bonds of stalwart companies like General Electric, Alcoa, and Prudential  traded like garbage paper - junk bond yields implied a rate of corporate defaults greater than that at the height of the Great Depression ,   Even agency debt traded at yields well in excess of treasury yields.  All of this resulted in the destruction of a huge amount of wealth in the hands of private investors, pension funds, and various financial institutions. 
   Everyone was poorer and knew that everyone else was poorer and would soon stop spending money.  Companies shrank their inventories, consumers stopped buying, and the fear of recession was added to the witches' brew of leverage and fraud to further undermine values of equities and debt instruments.  
   There is still considerable ambivalence among the politicians, the public, and even some economists about the role the government played in "bailing out" the financial system.  There is no doubt that many of us are a lot richer than we would have been had the government sat on its hands and allowed a run on the banks and money market funds to materialize.  This "wealth effect" is not spread evenly across the population - wealthy people almost certainly derived a greater benefit from the salvation of the financial system than their less fortunate brethren.  And, of course, there a probably a few short sellers who would actually have been better off if we had experienced a repeat of the Great Depression.  I hope we learned some lessons here but I am not so sure.  In a modern society, wealth is to a significant effect dependent on the legal, regulatory, and financial system, and these things, in turn, require competence, honesty and imagination on the part of government officials and politicians. It is often when we are most certain that the government is unnecessary that we are likely to need it the most.  I read that, in the early part of the last decade, the FDIC  experienced the longest period in its history without a bank closure and was laying off staff. In retrospect, of course, this should have been a very loud "bell" but it was heard by very, very few investors. In a world in which investors can electronically move funds around at will, there is likely to be an infectious hair trigger response to bad news.    An unfettered free market can move like an unherded pack of wild horses and plunge over a cliff. We are now a safe distance from the edge and should use this opportunity to reflect on what happened and how we can best move forward.      

Disclosure: I am long GE, AA, PRU.