Esoteric Dissertations from a One-Track Mind

March 25, 2008

The Credit Crisis: Too Big To Fail

Filed under: economy, politics — Tags: , — codesmithy @ 8:17 am

The New Yorker has a piece by James Surowiecki called “Too Dumb to Fail.” The moral hazard that the action sets up should be obvious to anyone. The underlying point is the same. Any numb-skull can “loan” people money that isn’t going to get returned. The reason the banks were justified in making there enormous profits was because they loaned people money who were going to pay back back huge premiums on the initial money lent. Now it turns out that these financial wizards are not the sober judges of character they claimed to be. Now they are rushing for the aid of the government to save them from all the borrowers who cheated them. Who could have predicted it? As it turns out, anyone who looked seriously at the problem.

Eliot Spitzer, yes that one, wrote an editorial in the Washington Post that directly links the Bush Administration to predatory lending practices. This takes some explanation so stay with me. As we have examined before, subprime is not the cause of the current credit woes. It was merely the first market to go because it was the sketchiest. It was just the canary in the coal mine. When the housing market took a dive, borrowers found that they have a negative equity in their home, that is they owe more on their home than it is worth. Every borrower faced with negative equity has a huge incentive to just walk away from their home. Why would any sensible borrower want to pay a significant amount over the price of their home in addition to the interest on that principle? The answer is that they won’t. In no recourse that is pretty much the end of it, banks foreclose, the people move out and it is a done deal.

In the meantime, the banks used exotic accounting practices, including the infamous mark-to-market accounting, to try to predict the value of their investments. Mark-to-market books a profit immediately. It looks great on quarter reports since the entire value of the deal comes in as one lump sum. For example, a loan for $100,000 at 6% that is paid over 30 years would immediately be booked as a $115,838.53 profit. However, the problem is that when the asset goes south, you need to revise and restate earnings. The Enron debacle mostly revolved around them trying to hide their massive liabilities using creative accounting practices through special purpose entities. It should be noted, Enron did this with the help and support of many investment banks.  It was a house of cards waiting to fall just like this current debacle.  Just imagine the result on a balance sheet when a $115,838.53 profit, booked quarters ago turns into a $20,000 loss.  That is what is happening to the fundamentals of each one of these securities every time a house is foreclosed.  Bears Sterns had tremendous leverage, that is for every dollar they kept in reserve they lent about $30.  This basically means about a 3% loss wipes them out.  Now imagine a housing correction of 10%, 20%, 30% and we can easily see why such a bank is in trouble.

Eliot Spitzer and other attorney generals wanted to enforce the predatory lending laws in their states.  The Bush Administration used an obscure government agency known as the Office of the Comptroller of the Currency to prevent states from enacting their consumer protection laws.  This is not “gee whiz” we didn’t know, it is the Bush Administration knew about the problem and actively sought to enable it.  In many ways it is equivalent to the corruption we see in the Iraq war reconstruction.  Corporations were finding these deals extraordinarily (and fictitiously) profitable and they used their influence at the federal level to protect it.  The ultimate result is a disaster for everyone.  The hardest immediate losses will be foreign governments who flooded our market with capital to help American consumers to continue to purchase their goods.  Much of that debt will simply be bad, but this country’s economy is going to be hamstrung for a very long trying to meet our debt obligations.  The debt is going to be particularly crippling when faced with the prospect of trying to rebuild our infrastructure while meeting our prior obligations to foreign lenders.

In short, there is no such thing as too big or too dumb to fail because this nation is proving both of those premises false on their face.

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