The Subprime Mess, Continued

To get a running start, see my previous note on this subject.  In some ways it resembles several earlier crises, such as the savings and loan meltdown of a few years ago.

This has been a fairly typical speculative waterspout:  houses, in this instance, go higher and higher, propelled by wormy mortgages that are flogged off to institutional suckers. Rising prices draw in more and more speculators until everything is overpriced, whereupon the waterspout collapses.

Many of the wormy mortgages really have lost a lot of value; many will never be paid off.  The houses still exist, though, and do represent some value sooner or later.  (On the other hand, repossessing and then reselling a house is a costly process, to be avoided.)

Anyway, the result of all this has been a loss of many of hundreds of billions of dollars, with attendant financial squeezes and acute discomfort.  The financial system has to some extent seized up. The markdown in the banks’ share prices has made it hard for them to raise money to replenish their capital, although there is in fact plenty of money, notably in the sovereign wealth funds.

The shotgun marriages imposed on Bear, Merrill and AIG are familiar to those who have read financial history.  J.P. Morgan (with my grandfather) would summon the heads of the major institutions to his library and confine them there until they decided what banks should be abandoned and which they should save.  “The rot stops here,” he would say, pointing, halting the falling dominoes.

This time it’s Messrs. Paulson and Bernanke, and their huge staffs.  In fact they are doing an excellent job, with no generosity, but creating a firebreak to contain the trouble – we hope.

Unlike the savings and loan crisis but like the dot-com collapse, our banking problem is worldwide, in part because banking is now itself worldwide.  Out of 88 major financial systems in the world, only 8 are decoupled from this decline.  Incidentally, both Europe and the Far Eastern institutions bitterly resent having been stuffed with unsound paper by U.S. institutions.

On the other hand, the U.S. economy is sufficiently robust and diversified so that except in the building-related trades and certain consumer industries the real economy’s growth is only expected to weaken by a percent or two over the next one or two years.  Let’s hope so.  I worry much more about how businesses are doing than about how their stocks are doing at any particular moment.

What do we do to get out of the mess?

  1. 1.Consider the approach used in Japan in a similar situation:  forbearance.  In this technique the government provides incentives to the homeowners to stay, and for creditors not to evict.  This was not too successful.
  2. Create a government entity along the lines of the Resolution Trust Company to acquire many of the suspect financial assets, and then sell them off at leisure.  At much less cost than had been feared, this solution wound down the savings and loan crisis.  (The above was written before the policy along these lines was announced.)
  3. Print money.  Some argue that pushing out money will not avert a slowdown:  “pushing on a string,” one says.  Not so.  It is happening now and does work, but is of course inflationary.

And to help make sure it doesn’t happen again?

  1. The rating agencies falsely certified a large part of the wormy paper as high quality when in fact it was junk.  But the rating agencies are paid by the issuers of the paper.  This is a conflict of interest.  The buyers should pay for the ratings, and the rating agencies should be responsible to them.
  2. Banks that originate mortgages and sell them downstream should, in my opinion, be obliged to retain some liability.
  3. Banks operating in the derivatives market should have to declare their derivatives positions.
  4. The grossly excessive leverage used by Bear and Lehman should have been flagged, and should be revealed in the future.  Nominally it was on the order of thirty times equity, but the equity was sufficiently weak so that the multiple was really much higher.  Similarly AIG misstated its liabilities in this sector, which six months ago it pronounced “minimal.”

*  *  *

The Treasury-Fed rescue team has, as I say, been doing splendidly, but only fifteen months ago our same Secretary Paulson declared in Fortune, “This is far and away the strongest global economy I’ve seen in my business lifetime.”  The article was entitled “The Greatest Economic Boom Ever” (July 23, 2007).  The decline surfaced the very next month and the month after that I put out the ‘The Subprime Mess’.

Moral:  Investing should not rely on macroeconomics.  The psychological feedback loop can override everything. ■