Tuesday, November 18, 2008

What credit crunch?

The bailout was supposed to alleviate a dramatic credit crunch, one that could possibly destroy the entire world economy- at least if you believed Paulson, Bush, et al. But stop and think for a moment... do you know anyone that wanted to get a loan and could not, due to the "crisis"? Anyone? I haven't heard a single story of someone that simply could not get financing. There are plenty of stories of economic hard times, but no specific lending problems that I've seen. So why does the data show that banks are lending more than ever???? Oh right, because the whole thing was a massive fraud to begin with. I keep forgetting.

The latest government numbers, through mid-October, show bank commercial and industrial loans up, bank commercial real estate loans rising and interbank loans climbing. Indeed, from September 2007 to mid-October of this year, the numbers in all three categories have climbed consistently.

It's a puzzle that's getting little attention, even as hundreds of billions of taxpayer dollars are devoted to fixing a problem that seems belied by government figures.

"Their own data seems to contradict their position," said V.V. Chari. "It would be valuable for them to explain what they're talking about."

h/t to Open Left


  1. No, there was a very real credit crunch. It just didn't work the way you (and other straightforward thinkers) imagine it would.

    It's like this: banks do not usually actually have all the money they are supposed to have. (Banks, unlike people, are allowed to use the same asset against multiple obligations; it's called "leverage". It's like a reverse shell game -- no matter which shell you pick, there's always a ball under it. The trick in this case is that the bank shuffles things around so that it's always the same ball.) In particular, a bank may not have enough cash assets to meet the transactions of the day.

    In order to make sure that the game run by the banks does not become obvious, which would mean bank failure, the banks constantly lend each other money for very short period at a reduced rate of interest -- the "overnight rate". Bank A has very little cash, but it has assets which will pay a million over the next week. Bank B loans bank A cash for the week to cover withdrawals, to be paid back out of that million.

    The problem is that most banks hold mortgage-backed securities and CDOs as some of their assets. When the housing crisis hit, these suddenly became worth nothing. (Strictly speaking, these assets still have value, which will eventually be paid out. But that value will be less than what was claimed, and since nobody will buy them any more, the immediate value is effectively zero.)

    Banks with cash became very reluctant to lend that cash to other banks, because nobody knows what the banks' assets are worth any more. This raised the overnight rate tremendously, making it very difficult for banks to get access to actual cash when they needed it. As a result, banks are now facing the prospect of being unable to pay out to customers.

    When banks cannot pay out to customers, they generally experience a run. Since they have leveraged their assets, they cannot afford to pay all their creditors (account-holders) at once, and fail. This creates a panic, which leads to runs on more banks, which likewise are unable to pay all their creditors and fail.

    As long as the bank has not run out of operating funds yet, the crisis is effectively invisible from the outside.

    However: this problem makes banks want to deleverage -- that is, reduce the ratio of money owed to the bank (in outstanding loans) to the market value of the bank's assets. There are two ways to do that: acquire more assets, or cut lending.

    If all the banks cut lending at once, that will be a disaster for the economy -- it will produce the kind of credit crunch you're thinking about, where ordinary people can't get loans because the banks can no longer loan anything. So either the banks must be prevented from deleveraging (which increases the likelihood of a panic and bank failures), or the banks must deleverage gradually (unlikely to happen because banks do not act in the public interest), or the banks must get more assets quickly.

    The original idea was that the government would buy the "worthless" assets at something resembling face price. This would have deleveraged the banks safely, but at enormous cost to the taxpayers. (Most estimates say that there are more "toxic" assets out there than the value of the entire "real" economy.) There was a very real danger that the dollar would lose all its value before the banks were deleveraged.

    This was controversial enough -- I don't know of any non-banker who was actually in favor of the outcome -- but it should be noted that the "toxic" assets do have some sort of value in the long term. It may take decades, but eventually all those mortgage-backed securities will pay off, and the credit swaps will pay out in some fractional way. So there would have been some return, just not much.

    The revised plan -- the one being carried out -- is in effect to just give the banks money (buying non-voting stock). Since banks do not run in the public interest, a bailout suggests to the banks that being leveraged is actually okay, so they do not in fact deleverage and instead pay executive bonuses and stock dividends, and move to acquire other banks.

  2. I understand fractional reserve banking, and I understand all the implications of "runs" on the bank. What I'm arguing is that when you have the Secretary of the Treasury telling Congress and the American public that they need this money in order to avoid a total financial collapse, that ludicrous hyperbole deserves to be mocked. Furthermore, to allow them to continue to threaten other types of lending (i.e. "we need this money or your credit cards, auto loans, student loans....")based on the type of interbank lending you are talking about here does a disservice to all the American public, especially those that are struggling to understand how this massive injustice could have come about.

    I think you and I agree, but we're phrasing it different ways. I submit that Paulson & others are threatening the type of credit crunch in the "real" economy as a way to extort money to allow the banks to hide the fact that many of them are insolvent at this point, allowing the "toxic" assets to remain hidden. A full, transparent accounting would clear this whole mess up rather quickly, but would also cause many banks to go under, therefore the powers that be will not allow that to happen.

  3. A full, transparent accounting would reveal that all banks are insolvent. An honest accounting would have to admit that the money the banks expect to be paid back on loans cannot be relied upon (particularly in this economy), and no leveraged bank can hope to cover all its obligations without counting those assets. Furthermore, nobody knows what the real, long-term value of mortgage-backed securities and CDOs is going to be, so unless an artificial value is applied to them (which will be incorrect, thus defeating the point of the exercise) accurate transparent accounting is actually impossible in most cases. Attempting to produce a full, transparent accounting will produce a panic and bank failures. Mind you, that might be a good thing, just as bankruptcy for the Big 3 auto makers might be a good thing.

    (Incidentally, it has been alleged that the deregulated toxic mortgage-backed securities were created specifically to allow banks to hide bad mortgages by chopping them into pieces and mixing the pieces with pieces of good mortgages, then selling the result. See, for example, this long but good article.)

  4. True, all banks are technically insolvent, at least to the extent that they depend upon maturity transformation. However, I didn't mean theoretical insolvency, I meant "closing the doors" insolvency. And I'll agree that full, transparent accounting is both impossible and impractical. But that's not to say that they couldn't agree on some closer-to-reality figure of say $.02 on the dollar for these "assets", rather than trying to keep the prices artificially inflated. By arguing that "someday" they'll be profitable is obscuring the fact that right now they are not.

    It's analogous to housing prices- a house is "worth" what it can be sold for. In much the same way, these "assets" are worthless, until and unless someone is willing to pay for them.

    Granted, it would produce a panic and bank failures. I believe that would be a good thing, as would automaker failures at this point.

  5. If we're going to discount the long-term value of mortgage-backed securities, then the same reasoning should force us to discount the long-term value of maturity transformation, and that would actually make any lending institution -- even one which was completely unleveraged -- come out insolvent in a full, transparent accounting. Which means there's something wrong with doing that.

  6. We already do "discount" the long-term value of maturity transformation, that's essentially the interest payment. When you are promising to pay back today's money tomorrow, plus interest then you are getting today's money at a discount to it's "value" later- that is maturity tranformation. Similarly, they already are discounting the long-term value of these securities in the sense that time is money. But what I'm saying is that you can't determine the value of these securities right now, you're trying to solve for too many variables. All we have are assumptions- i.e. assume that housing prices have 20% further to fall (from the peak), therefore that will lead to "x" number of mortgages underwater, of which "y" will default, which means for the BBB tranch of "z" bonds we can expect losses to the tune of "abc" dollars.

    But what I'm arguing is that all these banks already understand (now) what the risk of default is on these securities, and it's very high. That's what's behind their reluctance to allow market pricing on them. If they are holding securities that they thought were "worth" 10 billion before the crisis, but now are only able to sell them to each other for $200 million then that's what they are worth. Granted, whoever purchases them may, at some point, be able to turn a profit once they mature, but that's irrelevant to the discussion of what they're "worth" now.


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