What have we learned from the last eighteen months?
1. Banks have repeatedly claimed that they "shouldn't sell" assets to raise capital because their impairments were "temporary" and "would get better." Whether it be banks not foreclosing because they didn't want to book the loss to refusal to sell assets as they were "priced too low", the story has been the same. But in virtually every case, prices have continued to fall, in many cases dramatically. That is, the market isn't too pessimistic, it was too optimistic. Lesson: Banks that need to raise capital must not be permitted to avoid selling assets - whatever they are - under the theory that prices will improve with time. The best price is in fact today's price, not tomorrow's.
2. Taking over "bad assets" doesn't make them go away, it just shifts who takes the loss. Losses are in fact incurred when bad loans are made, not later when they default. Once the bad loan has been made the loss is inevitable; we are then left with the sole choice of who will eat the loss, but cannot prevent the loss from being realized. It is outrageous to expect the taxpayer to eat the losses incurred as a consequence of the foolish and even criminal actions of private parties, and such actions must not be contemplated. Lesson: "Bad bank" ideas are acceptable provided they are fully private and the losses assumed by those private parties but to the extent that such actions, as taken in part in the Fannie and Freddie debacle, by The Fed with the Maiden Lane LLCs and other similar schemes, force losses to be born by the taxpayer they amount to charging taxpayers with the cost of covering the criminal acts of private parties while allowing the malfeasors to abscond with their ill-gotten gains. This is incongruent with the principles of justice in America or, for that matter, any free society.
3. Firms will game the system whenever possible. For example, Merrill Lynch reportedly delivered bonuses in December days before the acquisition by Bank America closed, instead of in January as was customary, thereby dissipating $3 to 4 billion dollars that would have otherwise been in the firm on the day the transaction closed. Bank America subsequently went to Treasury and effectively demanded more TARP money to avoid scuttling the deal. Lesson: Any firm under a federal umbrella of any sort must operate with full transparency to the public so such outrageous conduct is unable to be swept under the rug and looting of the taxpayer cannot take place. If it is attempted anyway then "clawback" provisions must be immediately instituted or the provided "assistance" withdrawn.
4. Liquidity provision does not stop asset price deterioration. It in fact it accelerates deterioration and cuts off private lending activities as it suppresses interest rates - the very incentive (interest payments) that private investors need to complete deals. In a normal economy banks lend out money that is lent to them, whether through deposits or via debt issuance. As short-term rates have been effectively driven to zero there is no longer any private lending to these institutions, and thus, the normal private-money driven lending cycle has been destroyed. The "credit crunch" is a function of inadequate return being available to cover risk, with government being directly responsible for suppressing the rate of return available in the marketplace! Lesson: We have not solved anything through the myriad "liquidity programs" of The Fed and Treasury, but we sure have destroyed all private capital investment into our financial system and CREATED the credit crunch. Private capital must be enticed to return and to do so we must DECREASE liquidity guarantees and thus cause the rate of interest paid to RISE, not fall.
5. Insolvent institutions don't become less-insolvent over time, and the claimed "illiquidity" isn't - its insolvency. Proof is found in institutions like Citibank and Bank America that have had to tap the Treasury and Fed multiple times for various facilities to avoid implosion, each time at an ever-increasing cost. Lesson: You only get more broke the longer you wait to admit it; perform a cramdown of insolvent but systemically important institutions today and get it over with. We've solved nothing for these so-called "illiquid" banks despite throwing more than a trillion dollars at the problem and destroying private funding activity.
6. We have rising unemployment and north of 20 million illegal aliens in this nation. That is, we have more illegal aliens than we have unemployed workers, while states are spending billions that we don't have for their medical care and in many cases incarceration. Lesson: It is idiotic to permit illegal aliens to remain in this nation while our citizens and lawful immigrants (e.g. green card holders) are unable to find a job and states are going bankrupt.
7. Serial bubble-blowing looks good at the time, but in point of fact it is how one creates an economic depression. 1873 and 1929, and now 2007, prove this beyond all doubt. The mathematics cannot be swept under the carpet - any time lending-at-interest takes place, which is inherently necessary to entice people to loan capital, there must be liquidation events as nobody will ever (freely) loan money at less than the risk-free return rate. Since the lending rate will always exceed the GDP growth rate over longer periods of time and both lending and growth are compound functions (that is, yx) the law of exponents means you cannot "paper over" liquidation events. Lesson: Liquidations are inherently necessary in any capitalist system; the longer we try to put them off the more they compound and the worse the damage to the economy. This argues solidly for forcing liquidation NOW, even though it will hurt a lot, because it will hurt LESS than if we try to kick the can (again.) The errors of the past 20 years in 1987, 2000 and now 2007 cannot be un-done; we must take the pain in order to stop it, just as you must amputate a gangrenous foot lest it cause sepsis and kill the patient.
8. The market calls all bluffs. We have seen this repeatedly, starting with the August 2007 pronouncements of Henry Paulson and Ben Bernanke when they lowered the discount rate, claiming the economy was "fundamentally sound" and "subprime is contained." Likewise, when Paulson made his famous "bazooka" speech, the market shortly called the bluff and when Lehman's CEO said he was going to "burn the shorts." Any such BS spewed by anyone - whether a private party or government official - results in a near-immediate "all-in" response by the market. Lesson: You can only win by telling the truth; all lies are exposed and result in extraordinarily severe punishment being meted out by the market, destroying yet more value. Whatever damage exists must be admitted to, which is the precise opposite approach typically taken in Washington DC and Boardrooms across the nation.
9. Housing prices are too high and need to come down. All attempts to "fix housing" without price corrections to historical norms have failed. Redefault rates for modified mortgages are upwards of 50%, proving that modifying existing loans is not the answer - foreclosure is, and that modifications are in fact just another exercise in "kicking the can." Sustainable home prices and mortgage practices show that home prices must correct to between 2.5-3x incomes on a median basis, and sustainable mortgages are 30 year fixed notes with 20% down and a maximum 36% DTI. Lesson: "HOPE" and similar interferences with the housing market such as "DPA", low-down FHA loans and similar gimmicks are a fool's errand and will not resolve the problem. The solution is found in lower prices (and thus more affordable homes), not trying to prop up prices and sustain a popped bubble. Those who made foolish decisions to purchase or build beyond their ability to pay will inevitably default and this must not be interfered with, as that is how the market clears overcapacity and poor investment decisions.
Question: Where is Terry Tate now that we really need him?
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